New rules proposed for estate and gift taxes

New regulations proposed by the IRS seek to address the basic exclusion amount for estate and gift taxes which was doubled in 2017 under the Tax Cuts and Jobs Act (TCJA). The doubling of the exemption is scheduled to “sunset” as of January 1, 2026 under current law.

Under the Tax Cuts and Jobs Act passed in 2017 (TCJA), the basic exclusion amount for estate and gift tax purposes was doubled from a baseline of $5 million, as adjusted for inflation, to $10 million, as adjusted for inflation ($12,060,000 for 2022). This amount is often referred to as the estate and gift tax exemption (the “exemption”). The doubling of the exemption under the TCJA is available to each individual only during calendar years 2018 through 2025. Note that for a married couple, each spouse has his or her own exemption.

Which Estate Tax Gift Exemption Applies?

The temporary doubling of the exemption begs the question of how to calculate estate tax when an individual has made gifts using a larger exemption than the exemption available at the time of the individual’s death. The statutory framework does not offer a clear answer as to whether a higher exemption used during calendar years 2018 through 2025 can effectively lock in the increased exemption available in those years.

The IRS issued helpful regulations in 2019, which confirmed that, generally, exemption used by an individual in excess of the available exemption in the year of the individual’s death should not be “clawed back” and taxed, at the individual’s death to the extent of the exemption used in excess of the year-of-death exemption amount.

How to Lock In a Gift Exemption

In order to “lock in” the increased exemption, an individual must make completed gifts in excess of whatever reduced exemption might apply in the future. In order to lock-in the increased exemption, for example, an individual would need to make gifts of the full exemption (i.e., $12,060,000 in 2022).

The 2019 regulations reserved for clarification the question of whether locking in the increased exemption is available in situations in which an individual was deemed to make a “deferred gift,” where the individual’s retained rights with respect to the gifted property cause the property to be included in the individual’s gross estate for estate tax purposes. For example, if an individual makes a completed gift, but retains the right to receive all income from the gifted property, the gift is included in the individual’s gross estate for estate tax purposes.

Under the Proposed Regulations published on April 27, 2022 (REG-118913-21), gifts made by an individual that are also included in the individual’s gross estate for estate tax purposes (due to a retained interest, or other inclusionary or valuation rule), are “includable gifts.” These includable gifts do not lock in the larger exemption, unless the reason for inclusion in the individual’s gross estate is eliminated at least 18 months prior to the individual’s death.

Because some includable gifts would already be subject to inclusion under the Internal Revenue Code if the retained interest is held within three years of the individual’s death, it would appear that for certain includable gifts (e.g., a retained right to income), the retained interest would need to be eliminated at least four years and six months (18 months, plus three years) before the individual’s death in order to escape inclusion in the individual’s gross estate at death. The Proposed Regulations, however, are not entirely clear on this point.

Gifting a Promissory Note

Another approach taken by some individuals is to make a gift of an enforceable promissory note to a trust for the individual’s family rather than make a gift of specific assets currently. This gift of a promissory note (the “note structure”) should be treated as a completed gift of the face amount of the note, using exemption equal to the face amount of the note.

In order to lock in the increased exemption, the individual must satisfy the note by making payments in cash or other assets before the individual’s death.

We believe that satisfying the note in full at least three years before the individual’s death should prevent an IRS argument that the transferred assets should be included in the individual’s gross estate at death.

Under the Proposed Regulations, the individual should satisfy the remaining balance on the note at least 18 months before his or her death in order to use the full exemption and avoid inclusion of the remaining balance in the individual’s gross estate at death. We find this rule in the Proposed Regulations helpful in providing clarity to individuals who have used the note structure; provided, however, that without these Proposed Regulations an individual could argue that the note can be satisfied any time before death and have the intended tax effect.

The Proposed Regulations are subject to public comment and revisions made in response to those comments. Individuals who have utilized a note structure (or a form of “includable gift”), however, should be aware of the Proposed Regulations and keep in mind the potential timing requirements in order for the gift to achieve the intended tax goal.