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Estate and Gift Tax

Prop regs would protect pre-2026 gifts from post-2025 drop in exclusion amount

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

Preamble to Prop Reg REG-106706-18Prop Reg §20.2010-1, Prop Reg §20.2010-3; IR 2018-229, 11/20/2018

Proposed reg—Estate and Gift Taxes; Difference in the Basic Exclusion Amount

IRS has issued proposed regs and a news release concerning various effects of the increase in gift and estate tax exclusion amounts that are in effect from 2018 through 2025 and the post-2025 decrease in those amounts back to pre-2018 levels. Notably, the proposed regs would provide that taxpayers that take advantage of the increased exclusion amounts will not be adversely affected by the post-2025 decrease.

Background—the gift/estate tax exclusions, generally.  In computing the amount of Federal gift tax to be paid on a gift or the amount of Federal estate tax to be paid at death, the gift and estate tax provisions of the Code apply a unified rate schedule to the taxpayer’s cumulative taxable gifts and taxable estate on death to arrive at a net tentative tax. The net tentative tax then is reduced by a credit based on the applicable exclusion amount (AEA), which is the sum of the basic exclusion amount (BEA) within the meaning of Code Sec. 2010(c)(3) and, if applicable, the deceased spousal unused exclusion (DSUE) amount within the meaning of Code Sec. 2010(c)(4). In certain cases, the AEA also includes a “restored exclusion amount” pursuant to Notice 2017-15, 2017-6 IRB 783.

Prior to Jan. 1, 2018, for estates of decedents dying and gifts made beginning in 2011, Code Sec. 2010(c)(3) provided a BEA of $5 million, indexed for inflation after 2011. The credit is applied first against the gift tax, on a cumulative basis, as taxable gifts are made. To the extent that any credit remains at death, it is applied against the estate tax.

Background—changes to the gift/estate tax exclusions made by the Tax Cuts and Jobs Act. The Tax Cuts and Jobs Act (P.L. 115-97; TCJA) amended Code Sec. 2010(c)(3) to provide that, for decedents dying and gifts made after Dec. 31, 2017, and before Jan. 1, 2026, the BEA is increased by $5 million to $10 million as adjusted for inflation (increased BEA). On Jan. 1, 2026, the BEA will revert to $5 million. Thus, an individual or the individual’s estate may utilize the increased BEA to shelter from gift and estate taxes an additional $5 million of transfers made during the eight-year period beginning on Jan. 1, 2018, and ending on Dec. 31, 2025 (increased BEA period).

The TCJA also added Code Sec. 2001(g)(2) to the Code, which directs IRS to prescribe such regs as may be necessary or appropriate to carry out Code Sec. 2001 with respect to any difference between the BEA applicable at the time of the decedent’s death and the BEA applicable with respect to any gifts made by the decedent.

Background—federal gift tax computation.  The Federal gift tax is imposed by Code Sec. 2501 on an individual’s transfers by gift during each calendar year. The gift tax is determined under a seven-step computation required under Code Sec. 2502 and Code Sec. 2505 using the rate schedule set forth in Code Sec. 2001(c) as in effect for the calendar year in which the gifts are made.

First, Code Sec. 2502(a)(1) requires the determination of a tentative tax (that is, a tax unreduced by a credit amount) on the sum of all taxable gifts, whether made in the current year or in one or more prior periods (Step 1).

Second, Code Sec. 2502(a)(2) requires the determination of a tentative tax on the sum of the taxable gifts made in all prior periods (Step 2).

Third, Code Sec. 2502(a) requires the tentative tax determined in Step 2 to be subtracted from the tentative tax determined in Step 1 to arrive at the net tentative gift tax on the gifts made in the current year (Step 3).

Fourth, Code Sec. 2505(a)(1) requires the determination of a credit equal to the applicable credit amount within the meaning of Code Sec. 2010(c). The applicable credit amount is the tentative tax on the AEA determined as if the donor had died on the last day of the current calendar year. The AEA is the sum of the BEA as in effect for the year in which the gift was made, any DSUE amount as of the date of the gift as computed pursuant to Reg. § 25.2505-2, and any restored exclusion amount as of the date of the gift (Step 4).

Fifth, Code Sec. 2505(a)(2) and the flush language at the end of Code Sec. 2505(a) require the determination of the sum of the amounts allowable as a credit to offset the gift tax on gifts made by the donor in all preceding calendar periods. For purposes of this determination, the allowable credit for each preceding calendar period is the tentative tax, computed at the tax rates in effect for the current period, on the AEA for such prior period, but not exceeding the tentative tax on the gifts actually made during such prior period. Code Sec. 2505(c). (Step 5).

Sixth, Code Sec. 2505(a) requires that the total credit allowable for prior periods determined in Step 5 be subtracted from the credit for the current period determined in Step 4. (Step 6).

Finally, Code Sec. 2505(a) requires that the credit amount determined in Step 6 be subtracted from the net tentative gift tax determined in Step 3 (Step 7).

Background—federal estate tax computation. The Federal estate tax is imposed by Code Sec. 2001(a) on the transfer of a decedent’s taxable estate at death. The estate tax is determined under a five-step computation required under Code Sec. 2001 and Code Sec. 2010 using the same rate schedule used for gift tax purposes (thus referred to as the unified rate schedule) as in effect at the decedent’s death.

First, Code Sec. 2001(b)(1) requires the determination of a tentative tax (again, a tax unreduced by a credit amount) on the sum of the taxable estate and the adjusted taxable gifts, defined as all taxable gifts made after ’76 other than those included in the gross estate (Step 1).

Second, Code Sec. 2001(b)(2) and Code Sec. 2001(g) require the determination of a hypothetical gift tax (a gift tax reduced, but not to below zero, by the credit amounts allowable in the years of the gifts) on all post-’76 taxable gifts, whether or not included in the gross estate. The credit amount allowable for each year during which a gift was made is the tentative tax, computed using the tax rates in effect at the decedent’s death, on the AEA for that year, but not exceeding the tentative tax on the gifts made during that year. Code Sec. 2505(c). The AEA is the sum of the BEA as in effect for the year in which the gift was made, any DSUE amount as of the date of the gift as computed pursuant to Reg. § 25.2505-2, and any restored exclusion amount as of the date of the gift. This hypothetical gift tax is referred to as the gift tax payable (Step 2).

Third, Code Sec. 2001(b) requires the gift tax payable determined in Step 2 to be subtracted from the tentative tax determined in Step 1 to arrive at the net tentative estate tax (Step 3).

Fourth, Code Sec. 2010(a) and Code Sec. 2010(c) require the determination of a credit equal to the tentative tax on the AEA as in effect on the date of the decedent’s death. This credit may not exceed the net tentative estate tax. Code Sec. 2010(d). (Step 4).

Finally, Code Sec. 2010(a) requires that the credit amount determined in Step 4 be subtracted from the net tentative estate tax determined in Step 3. (Step 5).

Proposed regs consider various scenarios affected by the BEA changes. The preamble to the proposed regs considers four scenarios that involve the temporary nature of the increased BEA. For the first three of these scenarios, the preamble explains how the statutory law applies and that no regulatory pronouncement is needed in those scenarios. For the fourth scenario, proposed regs provide a rule change to prevent an adverse effect from the post-2025 decrease in the BEA.

For the sake of simplicity, the following discussion assumes that the AEA includes no DSUE or restored exclusion amount and thus, refers only to the BEA.

Three scenarios in which no reg is needed.  With respect to the following three scenarios, IRS explains how the existing statutory law applies:

Scenario 1. Effect of increase in BEA on gift tax.  The first situation considered is whether, for gift tax purposes, the increased BEA available during the increased BEA period is reduced by pre-2018 gifts on which gift tax actually was paid. This issue arises for donors, who made both pre-2018 gifts exceeding the then-applicable BEA, thus making gifts that incurred a gift tax liability, and additional gifts during the increased BEA period.

Step 3 of the gift tax determination requires the tentative tax on all gifts from prior periods to be subtracted from the tentative tax on the donor’s cumulative gifts (including the current gift). The gifts from prior periods include the pre-2018 gifts on which gift tax was paid. In this way, the full amount of the gift tax liability on the pre-2018 gifts is removed from the current year gift tax computation, regardless of whether that liability was sheltered from gift tax by the BEA and/or was satisfied by a gift tax payment. Steps 4 through 6 of the gift tax determination then require, in effect, that the BEA for the current year be reduced by the BEA allowable in prior periods against the gifts that were made by the donor in those prior periods. The increased BEA was not available in the years when the pre-2018 gifts were made and thus, was not allowable against those gifts. Accordingly, the gift tax determination appropriately reduces the increased BEA only by the amount of BEA allowable against prior period gifts, thereby ensuring that the increased BEA is not reduced by a prior gift on which gift tax in fact was paid.

…Scenario 2. Effect of increase in BEA on estate tax. The second situation considered is whether, for estate tax purposes, the increased BEA available during the increased BEA period is reduced by pre-2018 gifts on which gift tax actually was paid. This issue arises in the context of estates of decedents who both made pre-2018 gifts exceeding the then allowable BEA, thus making gifts that incurred a gift tax liability, and die during the increased BEA period.

Step 3 of the estate tax determination requires that the hypothetical gift tax on the decedent’s post-’76 taxable gifts be subtracted from the tentative tax on the sum of the taxable estate and adjusted taxable gifts. The post-’76 taxable gifts include the pre-2018 gifts on which gift tax was paid. In this way, the full amount of the gift tax liability on the pre-2018 gifts is removed from the estate tax computation, regardless of whether that liability was sheltered from gift tax by the BEA and/or was satisfied by a gift tax payment. Step 4 of the estate tax determination then requires that a credit on the amount of the BEA for the year of the decedent’s death be subtracted from the net tentative estate tax. As a result, the only time that the increased BEA enters into the computation of the estate tax is when the credit on the amount of BEA allowable in the year of the decedent’s death is netted against the tentative estate tax, which in turn already has been reduced by the hypothetical gift tax on the full amount of all post-’76 taxable gifts (whether or not gift tax was paid). Thus, the increased BEA is not reduced by the portion of any prior gift on which gift tax was paid, and the full amount of the increased BEA is available to compute the credit against the estate tax.

Scenario 3. Effect of decrease in BEA on gift tax.  The third situation considered is whether the gift tax on a gift made after the increased BEA period is inflated by a theoretical gift tax on a gift made during the increased BEA period that was sheltered from gift tax when made. If so, this would effectively reverse the benefit of the increased BEA available for gifts made during the increased BEA period. This issue arises in the case of donors who both made one or more gifts during the increased BEA period that were sheltered from gift tax by the increased BEA in effect during those years, and made a post-2025 gift.

Just as in Scenario 1, Step 3 of the gift tax determination directs that the tentative tax on gifts from prior periods be subtracted from the tentative tax on the donor’s cumulative gifts (including the current gift). The gift tax from prior periods includes the gift tax attributable to the gifts made during the increased BEA period. In this way, the full amount of the gift tax liability on the increased BEA period gifts is removed from the computation, regardless of whether that liability was sheltered from gift tax by the BEA or was satisfied by a gift tax payment. All that remains is the tentative gift tax on the donor’s current gift. Steps 4 through 6 of the gift tax determination then require that the credit based on the BEA for the current year be reduced by such credits allowable in prior periods. Even if the sum of the credits allowable for prior periods exceeds the credit based on the BEA in the current (post-2025) year, the tax on the current gift cannot exceed the tentative tax on that gift and thus will not be improperly inflated. The gift tax determination anticipates and avoids this situation, but no credit will be available against the tentative tax on the post-2025 gift.

Observation.  Thus, the increased BEA is a “use it or lose it” benefit with respect to gifts.

Proposed reg prevents loss of increased BEA where taxpayer dies after 2025. Scenario 4 considers the effect of the decrease in BEA on the estate tax. The issue is whether, for estate tax purposes, a gift made during the increased BEA period that was sheltered from gift tax by the increased BEA inflates a post-2025 estate tax liability. This will be the case if the estate tax computation fails to treat such gifts as sheltered from gift tax, in effect reversing the benefit of the increased BEA available for those gifts. This issue arises in the case of estates of decedents who both made gifts during the increased BEA period that were sheltered from gift tax by the increased BEA in effect during those years, and die after 2025.

In this case, the statutory requirements for the computation of the estate tax, in effect, retroactively eliminate the benefit of the increased BEA that was available for gifts made during the increased BEA period.

Illustration: Individual A made a gift of $11 million in 2018, when the BEA was $10 million. A dies in 2026, when the BEA is $5 million, with a taxable estate of $4 million. Based on a literal application of Code Sec. 2001(b), the estate tax would be approximately $3.6 million, which is equal to a 40% estate tax on $9 million (specifically, the $9 million being the sum of the $4 million taxable estate and $5 million of the 2018 gift sheltered from gift tax by the increased BEA). This in effect would impose estate tax on the portion of the 2018 gift that was sheltered from gift tax by the increased BEA allowable at that time.

IRS notes that Congress’ grant of regulatory authority in Code Sec. 2001(g)(2) to address situations in which differences exist between the BEA applicable to a decedent’s gifts and the BEA applicable to the decedent’s estate clearly permits IRS to address the situation in which a gift is made during the increased BEA period and the decedent dies after the increased BEA period ends.

The proposed regs would amend Reg. § 20.2010-1 to provide a special rule in cases where the portion of the credit as of the decedent’s date of death that is based on the BEA is less than the sum of the credit amounts attributable to the BEA allowable in computing gift tax payable within the meaning of Code Sec. 2001(b)(2). In that case, the portion of the credit against the net tentative estate tax that is attributable to the BEA would be based upon the greater of those two credit amounts. Specifically, if the total amount allowable as a credit, to the extent based solely on the BEA, in computing the gift tax payable on the decedent’s post-’76 taxable gifts, whether or not included in the gross estate, exceeds the credit amount, again to the extent based solely on the BEA in effect at the date of death, the estate tax Step 4 credit would be based on the larger amount of BEA. As modified, Step 4 of the estate tax determination therefore would require the determination of a credit equal to the tentative tax on the AEA as in effect on the date of the decedent’s death, where the BEA included in that AEA is the larger of (i) the BEA as in effect on the date of the decedent’s death under Code Sec. 2010(c)(3), or (ii) the total amount of the BEA allowable in determining Step 2 of the estate tax computation (that is, the gift tax payable). (Prop Reg §20.2010-1(c))

Proposed effective date.  The above proposed reg is proposed to be effective on and after the date of publication of a Treasury decision adopting these rules as final regs in the Federal Register. (Prop Reg §20.2010-1(f)(2))

References: For the estate/gift tax exclusion amount, see Federal Tax Coordinator 2d ¶ R-7100United States Tax Reporter Estate & Gift ¶ 20,104.

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