The Treasury Department is on the cusp of changing a taxpayer-friendly regulation regarding federal estate taxes, but there’s no need to panic. As long as taxpayers can show that their gifts are truly gifts, they should not be affected by the revision.
The proposed amendment is essentially designed to fix some loopholes in a 2019 regulation, sometimes referred to as the “anti-clawback regulation,” which was passed in response to the 2017 Tax Cuts and Jobs Act. The lucrative 2017 law doubled the value of the estate and gift tax exemption but only temporarily. That temporary increase, scheduled to expire at the end of 2025, allows people to avoid paying federal estate or gift taxes on $12.06 million (in 2022 inflation-adjusted dollars) of asset transfers (either during lifetime or at death). That same exemption was $5.49 million in 2017. Since the federal estate tax rate is 40%, the bigger exemption is saving wealthy taxpayers tens of millions of dollars.
The 2017 law raised concerns among taxpayers who wanted to make large gifts to take advantage of the higher tax exemption. They worried that their estates would be taxed on those tax-free lifetime gifts, if they died after 2025 when the bigger exemption reverted back to its lower level. In response, the Treasury Department issued a so-called anti-clawback regulation in 2019, reassuring taxpayers that they could take advantage of the higher estate and gift tax exemption throughout their lives if they made gifts before 2026. They would not need to pay taxes on such tax-free gifts even if the exemption at the time of their death was lower than the amount of lifetime gifts made.
But the IRS also recognized opportunities for abuse, which is why it is proposing an amendment to the anti-clawback regulation. The amendment provides some clarity regarding gifts that are not truly gifts, because the donor retains some benefit or control over the so-called “gift.” The goal of the amendment is to bar such artificial gifts from benefiting from the anti-clawback regulation. It is now clear that taxpayers cannot use tricks such as giving the gift of a promissory note (worth $12.06 million) to lock in the high exemption and leaving it unpaid until death. They are not actually giving anything away until they die, and therefore the promissory note will be part of their taxable estate and bound by the estate tax exemption amount existing when they die. Taxpayers should be very careful not to retain any control over or benefit from a “gift.” As an example, a person wishing to give ownership interests in a limited liability company should not serve as the company’s manager.
Say a donor puts his $12 million vacation home in Martha’s Vineyard into an LLC, specifying that the home must be kept in the family, and then he starts making gifts of the LLC ownership interests to his children. If the donor wants those gifts to maximize his current $12.06 million dollar exemption rather than being subject to a lower exemption that may be in effect at the time of his death, he shouldn’t serve as a manager of the LLC. He also couldn’t live rent-free in any property he has given away, if he wants to take advantage of the tax benefit. Similarly, if a mother puts money in a trust fund for her child, she cannot take advantage of the tax benefit if she serves as trustee of the fund and controls the distributions.
Taxpayers who use sophisticated techniques, such as grantor retained annuity trusts (GRATs), grantor retained income trusts (GRITs) and qualified personal residence trusts (QPRTs) before 2026, need to be aware that if they die during the annuity period or term of the trust, they will likely lose the benefit of the anti-clawback regulation.
If the amendment gets approved later this summer, taxpayers may want to consult with an attorney to make sure that they are properly following the new guidelines. But as long as they really are giving away their assets before 2026, they will likely be able to take advantage of the substantial tax benefit and pass more money on to their heirs.
Katherine R. Dorval is a partner with the Massachusetts law firm of Bowditch & Dewey. Dorval is an estate planning attorney who helps individuals, couples and families, both in Massachusetts and Rhode Island, with estate, trust, business succession planning and other complex estate and administration needs.