IRS Proposes Regulations Creating an Exception to the Anti-Clawback Rule

Effective January 1, 2018, the Tax Cuts and Jobs Act (TCJA) more than doubled the size of the federal estate tax exemption, from $5.49 million to $11.8 million, adjusted each year for inflation. 

In 2022, the exemption amount is $12.06 million for individuals and $24.12 million for married couples. Due to the sunset provisions in the TCJA, however, the exemption amount is scheduled to revert back to $5 million, adjusted for inflation, in 2026. The IRS estimates that the inflation-adjusted exclusion amount that year will be $6.8 million. 

Following enactment of the TCJA, a level of uncertainty existed as to whether gifts made while the exemption was high would still be tax free if the donor died after the exemption was reduced. For example, assume that in 2022, when the estate tax exemption is $12.06 million, a donor makes an $8 million cash gift. If the donor dies after the exemption is reduced to $6.8 million, it was unclear whether the donor would pay estate tax on the excess $1.2 million.

Consequently, the IRS issued Final Regulations in 2019 that created a special rule, referred to as the “Anti-Clawback Rule,” ensuring the donor’s estate would not be taxed on completed gifts that were tax free when made as a result of the higher exemption. Under 2019 regulations, then, the donor would not pay estate tax on the additional $1.2 million gift from the previous example. 

But the 2019 regulations created an opportunity for astute taxpayers to capture the benefit of the higher exemption by giving away property for estate and gift tax purposes without completely giving away the right to use and enjoy the property. As a result, the Final Regulations noted that there would be further consideration on how to treat gifts that are complete at the time of transfer but still includible in the decedent’s estate for federal estate tax purposes. 

New Proposed Regulations issued by the IRS on April 26, 2022, seek to curb the perceived abusive planning opportunities created under the 2019 regulations by clarifying that certain gifts that are includible in the decedent’s estate upon the decedent’s death will be excepted from the Anti-Clawback Rule and will only be given the benefit of the exemption available on the date of the donor’s death. This exception has been referred to the “Anti-Clawback Rule Exception.” Regulations propose that the Anti-Clawback Rule Exception will apply to the estates of decedents who die on or after April 27, 2022. 

Gifts includible in the decedent’s estate under the Anti-Clawback Rule Exception are those where the donor continues to have title, possession, use, benefit or control of the transferred property. Examples include gifts subject to a retained life estate under Internal Revenue Code (IRC) Section 2036; partnership freezes under IRC Section 2701; gifts made by enforceable promises; GRATS, GRUTS AND QPRTS pursuant to IRC Section 2702; and certain life insurance proceeds pursuant to IRC Section 2042. As exceptions to the special rule, these gifts will only be given the benefit of the exemption available on the date of the decedent’s death rather than the amount on the date the gift was made.

As an example, assume that when the estate tax exemption was $12.06 million, a donor transferred an enforceable $7 million promissory note to the donor’s child where the assets of the donor’s estate would be used to satisfy the note. Under 2019 regulations, the transfer would likely receive the benefit of the higher exemption amount even though the assets were includible in the donor’s estate. Under the proposed regulations, however, because the donor retains ownership over the assets until the donor’s death, and if the donor dies after a reduction of the exemption amount, the credit to be applied to the donor’s estate tax is based on the exemption at the time of the donor’s death. Accordingly, if the exemption on the date of the donor’s death is less than $7 million, estate tax would result. 

The Proposed Regulations note that the Anti-Clawback Rule Exception will not apply in certain situations, such as if the taxable amount of the transfer is de minimis (less than 5% of the transfer). 

In light of these Proposed Regulations, taxpayers who were relying on these types of planning strategies should reconsider their estate plans. If you’d like to learn more about the potential impact of these regulations, please contact us at [email protected].