The uncertainty surrounding tax treatment of gifts made after Dec. 31, 2017, and before Jan. 1, 2026, has finally come to an end. The Internal Revenue Service issued final regulations in November, amending Regs. §20.2010-1 to provide special rules that account for the higher basic exclusion amount in effect for the years 2018 through 2025. In T.D. 9884, which became effective on Nov. 26, 2019, the IRS clarified that gifts made during this time period will not be “clawed back” into the estate of a decedent dying after Dec. 21, 2025, even if the lifetime gifts exceed the lower exemption amount effective Jan. 1, 2026.
The Tax Cuts and Jobs Act of 2017 (TCJA) amended section 2010(c)(3) of the Internal Revenue Code to increase the basic exclusion amount (BEA) from $5 million to $10 million (adjusted for inflation) for decedents dying and gifts made after Dec. 31, 2017, and before Jan. 1, 2026. Like many of the individual tax changes in the TCJA, this increased BEA will sunset on Jan. 1, 2026, and the BEA will revert to $5 million, adjusted for inflation.
With the enormous difference between the BEA during the period 2018 through 2025 (the “increased BEA period”) and the BEA beginning in 2026, advisers have questioned whether the lower BEA could retroactively deny a taxpayer the full benefit of the higher exclusion amount for gifts made during the increased BEA period. For example, if Luke makes a $9 million gift in 2020 when the BEA is $11.58 million and dies in 2028 when the BEA is (let’s assume) $6.58 million, would the additional $5 million lifetime gifts be pulled back into Luke’s taxable estate? The final regulations confirm that Luke’s “excess” $5 million gift will not be clawed back into his estate, and taxpayers may make large gifts during the increased BEA period without being penalized when the BEA reverts to $5 million, adjusted for inflation.
The final regulations added a new paragraph (c) in Regs. §20.2010-1, “Special Rule in the Case of a Difference Between the Basic Exclusion Amount Applicable to Gifts and That Applicable at the Donor’s Date of Death.” The regulations set forth various rules that must be followed to take full advantage of the benefits and provide new examples to illustrate the rules. Some of the more important points to keep in mind are:
- The special rule is a “use or lose” benefit. Consider the following two examples, assuming that Mary, a single woman, has $20 million of assets and makes a gift in 2020 when the BEA is $11.58 million. Also assume a $6.58 million BEA at Mary’s death.
- If Mary makes a gift of her entire $11.58 million BEA, she will remove that amount from her estate. On her death, even though Mary’s lifetime gifts will exceed the $6.58 million BEA in the year of her death, she will not pay any tax on the “excess” gift. The full value of Mary’s estate will be subject to estate tax because she has no remaining BEA, but she will have removed the full $11.58 million from her taxable estate.
- Now assume Mary makes a gift of $6.58 million in 2020. She will not use all of her available BEA in 2020, but at her death there will be no more BEA available to use against her estate. The credit to be applied will be based on the $6.58 million BEA in the year of Mary’s death. She cannot reach back and claim the additional $5 million of BEA that was available when she made the lifetime gift.
- The application of a decedent’s deceased spousal unused exclusion (DSUE) and BEA is subject to ordering rules. Regs. §20.2010-1(c)(1)(ii) require that a taxpayer first utilize his DSUE against a gift before applying his own BEA. Assume the same facts as above except now Mary is married to Kevin. Kevin predeceases Mary, having used none of his BEA. Kevin’s personal representative made the portability election and now Mary has Kevin’s DSUE amount of $11.58 million in addition to her own BEA of $11.58 million. Mary makes a gift of $11.58 million. The ordering rules require that Mary first apply the DSUE amount to the gift, resulting in the full use of Kevin’s DSUE amount. On Mary’s death, the credit to be applied will be based on $18.16 million (DSUE of $11.58 million plus Mary’s BEA of $6.58 million). Hence, she has only her $6.58 million BEA amount available to allocate to her estate.
For married couples who may have the means to make large gifts but are unable to utilize both of their BEAs, be aware that splitting gifts may defeat the tax benefits provided by the special rule. For example, assume Bill and Jane are married, have a $30 million estate, and are at a point in their lives when they can make a gift of $11.58 million. Also assume that the BEA in 2026 is $6 million.
- If Bill and Jane split the gift, they will each use $5.79 million of their BEA. Together, they have transferred $11.58 million free of gift and estate tax. If Bill’s death occurs in 2026, however, only $210,000 of his BEA will remain to apply against his estate. Jane’s BEA will also be significantly reduced.
- If, instead, Bill makes the gift of $11.58 million, then on his death, he will have no BEA remaining to apply against his estate. Jane, however, will still have her entire BEA to apply against lifetime gifts or her estate. Together, they can transfer over $17.58 million free of gift and estate tax.
With the clarification provided by the final regulations, advisers can now confidently advise their clients that careful use of the higher exemptions between now and the end of 2025 can provide significant tax savings for clients with the means to make large gifts.
Jennifer Z. Flanagan is a partner with Vacovec, Mayotte & Singer LLP specializing in trusts and estates law for domestic and international clients. She is a member of the Massachusetts Bar Association’s Probate Law Section Council.