The Internal Revenue Service has published proposed regulations on the impact of the changes to the federal estate and gift tax basic exclusion amount (BEA), which doubled from $5 million to $10 million in 2018, but will return to $5 million in 2026. “Estate and Gift Taxes; Differences in the Basic Exclusion Amount,” REG-106706-18, 83 F.R. 59343 (11/23/2018), Doc. No. 2018-25538.
The proposed regulations are intended to address a problem that will arise when gifts are made that take advantage of the new $10 million estate and gift tax exclusion amount, and then death occurs after the exclusion amount has reverted to $5 million. As will be explained below, a literal application of current statutes and regulations would result in additional estate tax on the gifts in excess of the $5 million exclusion, which is a result that Congress presumably did not intend.
The effect of the proposed regulation would be to deny any benefit for the increase in the BEA once the increase has expired (a result that I and other commentators have called the “use it or lose it” principle). That result was expected. What was not expected is that the proposed regulations would also deny any benefit for inflation adjustments to the BEA once gifts have been made that take advantage of the $10 million BEA. After 2025, when the BEA reverts to $5 million, both donors and the estates of decedents will not get any benefit from any increases in the BEA due to inflation until the inflation-adjusted BEA exceeds the total of any taxable gifts that were made before 2026. It is not clear whether this result is a policy decision by the IRS and the Treasury, or whether the consequences of inflation adjustments were not considered.
The proposed regulation is a response to a change made by what is commonly known as the “Tax Cuts and Jobs Act” (TCJA), P.L. 115-97, which doubled the BEA from $5 million to $10 million, but only for gifts made, and decedents dying, from January 1, 2018, to December 31, 2025. See I.R.C. § 2010(c)(3)(C). The act also created a new subsection 2001(g)(2), which directs the Secretary of the Treasury to adopt regulations “to carry out this section with respect to any difference” between the BEA in effect at the decedent’s death and the BEA applicable to gifts made by the decedent.
The stated purpose of the proposed regulations is to ensure that a decedent’s estate is not “inappropriately taxed” for gifts made while the BEA has been doubled.
In the “supplementary information” that precedes the proposed regulation, there is a background section in which the IRS explains the statutory procedures for calculating gift tax and estate tax, and examines four different scenarios, two with gift tax calculations and two with estate tax calculations, to determine if the increase and decrease in the BEA causes any unexpected or unintended results. The IRS concluded that the only problem was in the fourth scenario, in which an individual makes gifts using some or all of the increased BEA available from 2018 through 2025, and then dies after 2025. Because of the way the estate tax is calculated, gifts after 2017 and before 2026 in excess of the $5 million BEA, followed by death after 2025, will result in estate tax on the lifetime gifts that should have been sheltered from tax by the increased BEA that was in effect at the time of the gifts.
Of the two examples presented, the second example is clearest. The example assumes an individual makes a taxable gift of $11 million in 2018, when the BEA is $10 million, and then dies in 2026 with no taxable estate. Based on a literal application of I.R.C. § 2001(b), there would be an estate tax in 2026 of approximately $2 million even though there is no taxable estate.
As explained by the IRS, this happens because the BEA that was used to calculate the gift tax in 2018 is less than the BEA that is used to calculate the estate tax on the tentative tax base that includes those taxable gifts. The IRS summarized the calculation of the federal estate in five steps:
- A tentative tax is calculated on the sum of the taxable estate and the adjusted taxable gifts (taxable gifts made after 1976 that are not included in the gross estate).
- The gift tax “which would have been payable” (sometimes called the “gift tax payable”) is recalculated on all taxable gifts, whether or not included in the gross estate, based on the tax rates in effect at death and not the rates in effect at the time of the gifts.
- The net tentative estate tax is the tentative tax from step one less the “gift tax payable” from step two.
- A credit is calculated equal to the tentative tax on the applicable exclusion amount (AEA), which is the BEA for the year of death plus any deceased spousal exclusion (DSUE). (The IRS also refers to an exclusion adjustment for same-sex marriages under Notice 2017-15, but that adjustment is not relevant to this article.)
- The credit amount from step 4 is subtracted from the net tentative estate tax to determine the estate tax payable.
The $2 million of estate tax in the example comes from the difference between the BEA used in step two and the BEA used in step four.
Looking at the example in a slightly different way, the tentative tax base would be the sum of the taxable gift of $11 million and the taxable estate of $0. Of that $11 million, $5 million would be sheltered from tax by the BEA in effect at the death in 2026, and $1 million would be sheltered from tax because of the gift tax that was paid when the gift was made in 2018, so $5 million would be left that is still effectively subject to tax, which would be $2 million based on the 40% tax rate that applies once an estate exceeds the BEA.
The Proposed Regulations
The new proposed estate tax regulations would provide that, if a decedent has made taxable gifts during a period during which the BEA was larger than the BEA at death, and the BEA used by those gifts exceeds the BEA at death, then the BEA for that decedent’s estate tax calculation will be the BEA that was used by the lifetime gifts and not the statutory BEA that would otherwise apply.
So, the example in Prop. Reg. § 20.2010-2(c)(2) states that, if an individual has made $9 million in taxable gifts and used $9 million of the BEA, then dies after 2025 when the BEA reverts to $5 million, the BEA for computing the federal estate tax for the individual’s estate is $9 million and not $5 million. This eliminates the estate tax that would otherwise result from the taxable gifts.
The “Use It or Lose It” Principle
The proposed regulations confirm what most commentators assumed would be the result for estates of decedents dying after 2025, which is that any of the $10 million BEA that is not used before 2026 will effectively expire. There had been some hope that gifts would somehow use the $10 million exclusion “off the top,” which would be the result if post-2025 estates were allowed a BEA that was either (a) the unused BEA remaining at the end of 2025, or (b) the BEA in effect at death, whichever was the greater amount. The IRS has taken what is effectively the opposite approach, allowing post-2025 estate a BEA equal to the greater of (a) the BEA that was used before the end of 2025 (and not unused), or (b) the BEA in effect at death.
So, the proposed regulation will eliminate any estate tax on lifetime gifts made before 2026, but will not allow any carry-forward of any unused exclusion after the end of 2025.
Loss of Inflation Adjustments
What is somewhat surprising about the proposed regulation is that, although it would eliminate estate tax on lifetime gifts, it would also eliminate any benefit for inflation adjustments to the BEA after gifts are made that exceed the $5 million BEA, at least until the inflation adjustments to the BEA exceed the total of the gifts made that were sheltered from gift tax by the $10 million BEA.
To illustrate, assume that an individual, “A,” who is not married and has never been married (so there is no DSUE), makes $12 million in taxable gifts in 2018, when the BEA (adjusted for inflation) is $11,180,000 A would then pay gift tax of $328,000 on the $820,000 of gifts in excess of the BEA. In 2027, after the BEA has returned to $5 million, the BEA could be $6,580,000 after adjusting for inflation of about 1.8% per year. If A dies in 2027 with a taxable estate of $1,000,000, the BEA for A’s estate would be $11,180,000 under the proposed regulation, which would eliminate any estate tax on the lifetime gifts. But the entire $1,000,000 taxable estate would be subject to estate tax, resulting in a tax of $400,000, even though there were inflation adjustments to the BEA after the gifts were made in 2018 and after the $10 million BEA ended after 2025. If the $10 million BEA had not been enacted, a 1.8% inflation rate would have resulted in a BEA of $6,340,000 in 2025, and there would be additional BEA increases of $120,000 in both 2026 and 2027, and yet that total increase of $240,000 would have no effect on the calculation of the decedent’s estate tax.
Not having the benefit of inflation adjustments to the $10 million BEA would be consistent with the “use it or lose it” principle discussed above, but not having the benefit of inflation adjustments after the BEA reverts to $5 million seems strange, because normally a donor is entitled to increases in the BEA even after gifts have been made that have used up the BEA. So, for example, when the BEA increased from $5,450,000 in 2016 to $5,490,000 in 2017, donors could make tax-free taxable gifts of $40,000 even if they had already used up the exclusion of $5,450,000 in 2016.
The IRS is obviously aware that the BEA is adjusted for inflation, and there are several references to inflation adjustments in both the supplementary information and the proposed regulations themselves, and yet none of the examples provided by the IRS use an inflation-adjusted BEA and only refer to a $5 million or $10 million BEA. It is therefore not clear whether the IRS did not consider the effect of the proposed regulations on tax calculations with inflation adjustments, or considered the effect and decided that it should be ignored.
The “Gift Tax Payable” Adjustment
One alternative to adjusting the BEA for a decedent dying after 2025, as in the proposed regulations, is to adjust how the “gift tax payable” on lifetime gifts is calculated under IRC section 2001(b). (And this may have been what Congress was contemplating when it enacted section 2001(g)(2), which refers to regulations on the difference between the exclusion at the decedent’s death and the exclusion applicable to gifts by the decedent.)
When the BEA was increased to $5 million by the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010, the increase was still subject to the “sunset” provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), and there was a concern by practitioners and commentators that there would be estate tax on gifts made using that increased BEA if Congress allowed the increase to lapse. The estate tax would be the result of the same problem discussed above, and was often called a “clawback” tax on the gifts. However, the sunset provision of EGTRRA stated that, if the changes made by that act ceased to apply, the Internal Revenue Code would then be applied and administered as though the changes “had never been enacted.” If the “gift tax payable” on lifetime gifts is calculated under section 2001(b) as though the $5 million exclusion amount had never been enacted, then the gift tax payable would be calculated using a $1 million BEA instead of a $5 million, and the resulting (hypothetical) gift tax would eliminate any “clawback” tax on lifetime gifts that used the larger BEA. For additional information, see Evans, Daniel B., “Complications from Changes in the Exclusion,” Steve Leimberg’s Estate Planning Newsletter # 1768 (1/31/2011), and “Clawback Has No Teeth,” Steve Leimberg’s Estate Planning Newsletter #1729 (2/23/2012).
It is worth considering whether the same approach should be applied to the temporary increase in the BEA.
If the gift tax payable on lifetime gifts made using the $10 million BEA is recalculated after 2025 using the $5 million BEA (i.e., the BEA that would have applied if the TCJA had not been enacted), then the estate tax on lifetime gifts is eliminated, and the estate would get the benefit of any inflation increases to the BEA that might have occurred after the gifts.
So, going back to the example above of a $12 million gift in 2018, and the decedent’s death in 2027 with a $1 million estate, the BEA in 2018 would have been $5,600,000 if the TCJA had not increased the BEA to $10 million. If that BEA is used the calculate the gift tax payable on the $12 million gift for purposes of calculating the estate tax in 2027, then the gift tax would be $2,560,000 instead of $328,000, and the estate tax on the $1,000,000 estate would be $8,000 instead of $400,000. Of the tentative tax base of $13 million ($12 million gift plus $1 million taxable estate), $6,400,000 ($12,000,000 gift less presumed BEA of $5,600,000 in 2018) would be sheltered by having been subject to gift tax in 2018, and $6,580,000 would be sheltered by the BEA in 2027, leaving only $20,000 subject to estate tax.
Even if it is determined that donors should not get any benefit from unused inflation adjustments before 2026, but only inflation adjustments after 2025, it is still possible to achieve that result by recalculating the “gift tax payable” for taxable gifts before 2026 using either the BEA that would have been in effect at the end of 2025 if the $10 million BEA had not been enacted. Using the same inflation adjustments described above, the BEA would have been $6,340,000 in 2025 if the $10 million BEA had never been enacted. If the “gift tax payable” on the 2018 gift of $12 million is recalculated using that BEA instead of the $11,180,000 BEA in effect in 2018, the “gift tax payable” would be $2,264,000, and the estate tax on the $1,000,000 estate would be $304,000 instead of the $400,000 required by the proposed regulations. In effect, the estate would get the benefit of the $240,000 increase in the BEA in 2026 and 2027, which reduces the estate tax by $96,000 (40% of $240,000).
It is not clear what Congress intended the “right” result to be, but these alternate approaches should at least be considered instead of the regulations actually proposed.
The Most Administrable Solution
The IRS describes its proposed regulation, increasing the BEA for a decedent after 2025 to be not less than the exclusion used by the decedent before 2026, as the “most administrable solution.” But compared to what?
The approach taken by the proposed regulations would appear to be simpler, and more “administrable” than the recalculation of “gift tax payable” using a lesser BEA, as proposed above. But the recalculation of gift tax payable seems to be required already by the instructions to Form 706, due to changes in tax rates in 2010. (See the Line 7 Worksheet on pages 8 and 9 of the Instructions for Form 706.) The recalculation of gift tax payable using a lower BEA for deaths after 2025 could use the same worksheet, just using a different number for the BEA in the years from 2018 to 2025. The recalculation of gift tax payable would therefore be consistent with current forms and would not require significant additional time or effort in preparing estate tax returns.
It appears that the IRS might have been trying to propose regulations that could be applied to all future changes that Congress might enact for the BEA, and would not be limited to the decrease in the BEA now scheduled to occur in 2026. However, depriving taxpayers of the benefit of future inflation adjustments merely to try to anticipate the effects of legislation Congress has not yet enacted would not seem to be an appropriate regulatory goal.
The Gift Tax Credit Issue
The supplementary information that accompanied the proposed regulations explained that federal gift tax calculations are different from federal estate tax calculations, and concluded that the changes in the BEA do not cause any gift tax problems. However, a different conclusion is possible if the inflation adjustments to the BEA are considered.
The third situation the IRS considered is whether gift tax after 2025 might be increased by gifts made before 2026 that were sheltered from tax by the increased BEA. The IRS concluded that no additional gift tax would result, because in a gift tax calculation, the gift tax in the current year is calculated by determining the tax on the total of the gifts in the current year and the gifts in all prior years, and then subtracting the tax on the gifts in the prior years. Therefore, “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.” Which is true, but doesn’t address the problem of how the gift tax credit for the BEA is calculated.
Normally, the credit against the gift tax is calculated by taking the tax on the applicable exclusion amount (AEA) for the current year, which is the sum of the BEA and any deceased spousal unused exclusion (DSUE), and subtracting the total credit allowable for prior years. That result can’t be negative (or, as the IRS put it, “the tax on the current gift cannot exceed the tentative tax on that gift”), so there is no increase in the gift tax payable even if the credit allowed for prior years exceeds the AEA (or BEA) for the current year. However, that conclusion fails to address the problem of increases in the BEA due to inflation.
Returning to the estate tax example, assume that A has made $12 million in gifts in 2018, survives to 2027, and then makes a taxable gift of $1 million. The tentative gift tax will be the tax on $13 million (current year and prior years gifts) less the tax on $12 million (prior years’ gifts), which will be $400,000 (or 40% of $1 million). The credit allowed in 2018 was the tax on $11,180,000, or $4,417,800, and credit in 2027 is assumed to be the tax on $6,580,000 ($5 million with inflation at 1.8%), or $2,560,000. The difference between the two, $2,560,000 less $4,417,800, would be a negative number, so there is no credit, and the tax on the $1 million gift will be $400,000.
As in the case of the estate tax calculation, the increases in the BEA from 2018 to 2025, and from 2025 to 2027, have been completely ignored, even though donors are normally entitled to make additional tax-free gifts when the exclusion is increased for inflation.
Unlike the estate tax situation, this is not a problem with section 2001, but with section 2505(a)(2) and the determination of “the amounts allowable as a credit” for the gifts in prior years. In theory, the problem could be resolved with an adjustment similar to the adjustment described above for estate tax calculations, in which the gift tax payable on lifetime gifts is increased to reflect the later decrease in the BEA. For gift tax purposes, the adjustment is in the credit allowed instead of the gift tax payable, but the principle is the same.
And, as in the case of the gift tax payable for estate tax purposes, there is already a worksheet for recalculating the credits allowable for prior years. See “Worksheet for Schedule B, Column C (Credit Allowable for Prior Periods),” from the Instructions for Form 709. All that would be needed is to provide a different number for BEA for the year of the gift in the prior year.
But does the IRS have the authority to issue regulations to implement that kind of change? The express authorization of the TCJA is found in section 2001(g) of Chapter 11, relating to the estate tax, and refers to the calculation of estate tax and not gift tax. So there is no clear indication that Congress saw any problem, and no clear authority for the IRS to vary the literal application of the section 2505. However, this is an issue that the IRS should still consider, because it concluded that it had the authority to issue new regulations for section 2010 based on the authority of both section 2010(c)(6) and section 2001(g).
Although the proposed regulations eliminate any additional estate tax on lifetime gifts made using the increased basic exclusion amount that will be in effect during the years 2018 through 2025, the proposed regulations will prevent persons using that increased exclusion from getting any benefit from future inflation adjustments to the basic exclusion amount (at least until the inflation-adjusted exclusion is less than the gifts made using the larger exclusion in effect before 2026). The IRS should be required to address this issue explicitly and explain why it has chosen the approach taken by the proposed regulations and not alternative approaches that would preserve the benefit of future exclusion increases without any undue administrative burden.
A similar problem exists for gift tax calculations, for which no regulations have been proposed, and the IRS should be required to address that issue as well.