Clawback of the Gift Tax

Editor: Frank J. O’Connell Jr., CPA, Esq.

Estates, Trusts & Gifts

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312 (the 2010 Tax Relief Act), was signed into law on December 17, 2010. It increases the lifetime gift tax exclusion from $1 million (as it had been since 2002) to a full $5 million for 2011 and 2012. Although this allows taxpayers to now make additional lifetime gifts of at least $4 million during 2011 or 2012 without paying gift tax, there is concern that the IRS will attempt to assess either an additional gift tax or extra estate tax if the lifetime exclusion is subsequently reduced. The reduction in the exclusion might occur if:

• Congress enacts a new law providing that the gift tax exclusion is lower after 2012 (for example, setting it at $3.5 million as recommended in President Barack Obama’s 2012 budget proposal); or
• Congress does nothing, and the 2010 Tax Relief Act provisions are allowed to sunset.

This sunset rule exists because the 2010 Tax Relief Act (§§304 and 101(a)(1)) amends Section 901 of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), P.L. 107-16, to provide that “the Internal Revenue Code of 1986 . . . shall be applied and administered to years, estates, gifts and transfers [after December 31, 2012,] as if the provisions and amendments in [this act] had never been enacted.” The effect of the sunset would be that the lifetime exclusion for gift tax purposes would revert to the 2002 level of $1 million, and the top tax rate would become 55%.

Therefore, because of the uncertainly about what Congress may or may not do in the future, a taxpayer who is considering making a $5 million tax-free gift in 2011 or 2012 might be concerned that either an additional gift tax will be assessed at the time a subsequent gift is made or an additional estate tax will be imposed upon death. For example, if a $5 million gift is made in 2012 but the exclusion is reduced to $1 million in 2013, will the taxpayer owe additional tax on the excess $4 million? Overall, the answer is likely to be different for gift tax purposes than it is for estate tax purposes. This item shows why a “clawback” of additional gift tax on a 2011 or 2012 gift will not be triggered by a subsequent gift in 2013 or after, whereas there could be a “recapture” on a large 2011 or 2012 gift in the form of additional estate tax at death.

Observation: Practitioners are divided on whether the clawback in the form of additional estate tax will occur for deaths after 2012 as described below if the EGTRRA estate tax provisions are allowed to sunset. Under this scenario, some argue that “would have been payable” in Sec. 2001(b)(2) means “would have been payable if EGTRRA were never enacted,” which would avoid the clawback problem. This point is discussed in more detail below.

Overview

As a broad concept, the gift and estate taxes are both computed by adding the current transfer amount (either a gift value or assets held at death) to prior-year gifts and computing a tentative tax on the total, then reducing that tentative tax by the tax on the prior gifts, leaving the tax owed on the current transfer. The difference is how the unified credit that was used to offset the prior gifts is factored into those calculations.

More specifically, gift tax is basically computed as (1) the tentative tax (per Sec. 2502(a)(1)(A)) on the total of current-year and prior lifetime gifts, reduced by (2) the tentative tax (per Sec. 2502(a)(1)(B)) on only the prior-year gifts, further reduced by (3) the Sec. 2505 unified credit that has not been previously used. On the other hand, the estate tax is computed as (1) the tentative tax (per Sec. 2001(b)(1)) on the total of the lifetime and at-death transfers, reduced by (2) the gift tax checks that “would have been payable” on the lifetime gifts (per Sec. 2001(b)(2)), further reduced by (3) the full unified credit allowed by Sec. 2010(c)(1) for the year of death (regardless of how much was used during one’s lifetime). Therefore, the distinction is that the subtraction at item 2 for gift tax is a “tentative tax” (before any offset for unified credit), whereas item 2 of estate tax is the actual amount payable (after all unified credits have been used). Note that all these tax calculations, including those involving prior-year gifts, are computed by substituting the current-year tax rates (per Secs. 2505(a) for gift tax and 2001(g) for estate tax) instead of the rates actually applicable in the prior year.

Gift Tax

The best way to fully understand the impact of this distinction is to apply the specific Code sections using hypothetical examples and calculate the actual tax liability.

Example 1: K, who has never used any lifetime exclusion, makes a gift of $4 million during 2011, when the exclusion is $5 million and the tax rate is a flat 35%. In 2013, K makes another gift of an additional $1.2 million, but this is after Congress has reduced the lifetime exclusion to $1 million and raised the tax rate to a flat 50%. The question is whether any extra gift tax is triggered on K’s $1.2 million gift in 2013, solely based on the fact that she paid no gift tax on the previous $4 million gift in 2011, even though $4 million exceeds the cumulative lifetime exclusion (of only $1 million) available in 2013.

As shown in Exhibit 1, the answer is “no.” K’s gift tax liability in 2013 is only $600,000, representing 50% of the $1.2 million gift made in 2013, even though her cumulative lifetime gifts of $5.2 million exceed her lifetime exclusion in 2013 (of only $1 million) by $4.2 million.

The key to understanding why this is true is at lines 8–10 of Exhibit 1, which compute (for purposes of the 2013 gift) the amount of unified credit not previously utilized. Even though the gift tax unified credit actually utilized (line 10) in 2011 was $1.4 million, the amount considered to have been previously utilized (line 8) in the 2013 calculation is $2 million, representing the 2011 gift of $4 million at the 2013 tax rate of 50%. This change is because the last sentence of Sec. 2505(a) now provides that in computing the amount by which the current-year tentative gift tax should be reduced because of prior-year gifts, the current-year tax rates are to be applied to the prior-year gifts. The more important aspect, however, is that in either case, this prior utilization (regardless of whether it had been $1.4 million at 35% or $2 million at 50%) exceeds the unified credit of only $500,000 available in 2013 (computed as the $1 million exclusion at a 50% tax rate). Nevertheless, this overutilization does not produce a “negative credit” that K has to repay. Instead, line 10 of the exhibit shows that the Sec. 2505 gift tax unified credit that is available to K in 2013 is merely zero. This treatment and result are confirmed by the IRS instructions to the 2010 gift tax return (Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return), which were released on March 30, 2011. In regard to column K of the Form 709 worksheet used to compute the unified credit allowable for prior periods, page 11 of the IRS instructions specifies, “Do not enter less than zero.”

Estate Tax

However, as described in the overview section above, the estate tax is calculated differently. Specifically, the tentative tax on the combined total of estate assets and prior gifts is not offset by a tentative tax on prior gifts and the portion of the unified credit not previously used (as it was with the gift tax). Instead, it is reduced (under Sec. 2001(b)(2)) first by the gift tax, which would have been payable on the full amount of the lifetime gifts. This essentially represents only the amount that the taxpayer would have paid on prior taxable gifts, after using the unified credit that would have been available that year, assuming the tax rates in existence at death had been applicable in the year of the gift per Sec. 2001(g). After the tentative tax on the total has been reduced for these hypothetical payments that would have been made on the prior gifts, the remaining tentative tax is offset by the full amount of the unified credit based on the laws in existence at the time of death. Unfortunately, if no gift tax would have been payable on the prior gifts (because the applicable exclusion was higher at the time of the gift than at the time of death), this simply means that the tentative tax will not be reduced, leaving more estate tax to be paid.

This is illustrated in Exhibit 2, which shows three different hypothetical taxpayers who each gifted $5 million during their lifetimes and then died owning $10 million at death. In all three examples, if the gift or death occurs during 2011 or 2012, it is assumed that the exclusion was $5 million and the tax rate was a flat 35%. However, if the gift or death was in 2013 or 2014, it is assumed that the exclusion is only $1 million with a 55% flat tax rate.

Example 2: A both makes a gift and dies under the old rules; B both makes a gift and dies under the new rules; and C makes a gift while the higher exclusion exists but does not die until after the lower exclusion (and higher rates) apply. (Note that in order to maintain comparability, the three-year rule of Sec. 2035(b) is being ignored for purposes of these illustrations.)

As shown in Exhibit 2, both A and B have what most people would consider to be a “logical” answer: A died in 2012, and her estate pays $3.5 million of estate tax on $10 million of estate assets, whereas B died in 2014, and his estate pays $5.5 million of estate tax on $10 million of assets. In addition to the estate tax, however, B also paid gift tax of $2.2 million on his $5 million gift in 2013 (computed as the $5 million gift less $1 million exclusion at a 55% tax rate).

However, C made his gift in 2011 when the exclusion was $5 million, so no gift tax was paid. Therefore, the reduction in the tentative tax (per Sec. 2001(b)(2) at line 5 of the exhibit) for gift tax paid on prior gifts is zero. This means that C’s estate will pay a total of $7.7 million of estate tax on $10 million of estate assets. This effectively represents 55% of $14 million, even though C owned only $10 million at death. Some would refer to this as a clawback of the gift tax on $4 million, which C managed to avoid by making a $5 million tax-free gift in 2011, even though the exclusion at his death in 2013 had dropped to only $1 million. However, this merely illustrates a recapture under the unified transfer tax system, since the total $7.7 million of tax that C paid is the same as the total amount that B paid, with the main difference being that B’s tax was paid in two parts: $2.2 million of gift tax paid in 2013 and $5.5 million of estate tax paid in 2014.

Admittedly, the calculations and worksheets described above may represent only one potential interpretation of the tax laws. Ultimately, the IRS needs to specifically clarify and confirm that there is no alternate interpretation that would prevent the recapture of the forgone gift tax in the form of additional estate tax at death. Obviously, taxpayers would prefer the IRS to conclude that in the example above, C’s estate could in fact be eligible for a reduction of the estate tax (under Sec. 2001(b)(2) at line 5 of Exhibit 2) for a hypothetical gift tax that would have been paid on the prior gifts. Although this appears unlikely based on current laws, it may be possible if the EGTRRA estate tax provisions are allowed to passively sunset rather than being affirmatively changed by Congress. If sunset occurs, it could be argued that the increased $5 million exclusion would be deemed to have never been enacted, thus conceivably requiring the IRS to conclude that the gift tax that would have been paid should be calculated using the pre-EGTRRA exclusion amount of $1 million, thus avoiding the recapture at death. Another scenario is that Congress actually affirmatively changes the laws for 2013 and beyond, in which case it can (and should) clarify exactly how these clawback and/or recapture at death calculations will be implemented.

The other issue for advisers to consider is that the estate tax liability (including the potential recapture amount) may actually exceed the estate assets remaining at death. Thus, a prudent adviser should evaluate (based on the particular estate plan division of assets and the family dynamics) whether it is preferable to have the gift tax recipients agree in advance that they will reimburse the estate for any additional (recaptured) estate tax or whether it is better to leave the estate in a situation where the executor tells the IRS that the tax cannot be paid because there are not sufficient assets. Presumably, the latter decision will be used only if the same beneficiaries will be receiving both the gifted assets and the residuary estate assets.

Conclusion

Ultimately, taxpayers need to decide whether to make large gifts in 2011 or 2012 while the exclusion is at the higher $5 million level. If that exclusion continues beyond 2012, the issue of clawback or recapture at death will disappear and should not prevent a taxpayer from making a desired gift. However, even if the benefit of making tax-free gifts in 2011 and 2012 is recaptured, the exhibits show that this merely puts taxpayers back in the same position they would have been in anyway.

Even if recapture occurs, taxpayers can still gain a substantial advantage by making the gift. This could occur because the property has appreciated subsequent to the gift (since only the original gift amount is recaptured, not the value of that property at the date of death) or if the taxpayers have further depleted their net worth by continuing to pay income tax on the gifted property during their lifetimes. Therefore, whether the exclusion remains high or drops later, it appears that taxpayers can gain an advantage by making gifts while the exclusion is $5 million.

EditorNotes

Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or frank.oconnell@crowehorwath.com.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.