Estate planning update: Summary of recent proposed regulations

Editor: Anthony Bakale, CPA

This item summarizes the impact of two sets of proposed regulations issued by Treasury in early 2022. One set addresses a limitation on the special rule regarding a difference in the basic exclusion amount, and the other addresses updates of actuarial tables for valuing annuities, life estates, remainder interests, etc.

Limitation on the special rule

The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, amended Sec. 2010(c)(3), increasing the basic exclusion amount (BEA) from $5 million to $10 million (adjusted for inflation) for decedents dying or making gifts after Dec. 31, 2017, and before Jan. 1, 2026 (the “TCJA period”). In 2019, Treasury issued final regulations to address situations where the BEA allowable on the date of a gift exceeds the BEA on the date of death. These provisions, included in Regs. Sec. 20.2010-1(c), are commonly referred to as the anti-clawback special rule.

As an example of the special rule:

Example: In 2022, individual B gifts $12 million to his children when the BEA is at $12.06 million. B then dies in 2026, when the BEA has dropped back down to $6.8 million. The full $12 million of BEA consumed at the time of the gift would be available to offset the gross estate on the Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, filed by B’s executor.

On April 27, 2022, the IRS issued proposed regulations (REG-118913-21) that would provide certain exceptions to the special rule for completed gifts, under Prop. Regs. Sec. 20.2010-1(c)(3). The Background section of the proposed regulations’ preamble states that the basic concept of the special rule under Regs. Sec. 20.2010-1(c) is that it “ensures that the estate of a donor is not taxed on completed gifts that, as a result of the increased BEA, were free of gift tax when made.”

The preamble further points out that while the Internal Revenue Code and the regulations do make a distinction, the special rule does not address the difference in treatment between:

(i) completed gifts that are treated as adjusted taxable gifts for estate tax purposes and that … are not included in the donor’s estate; and (ii) completed gifts that are treated as testamentary transfers for estate tax purposes and are included in the donor’s gross estate. [emphasis added]

The preamble spells out that the proposed regulations would generally “deny the benefit of the special rule to includible gifts” to address the lack of guidance on this point and sync up with the rest of the Code that does make this delineation. Earlier, the preamble reminds the reader that the preamble to the 2019 final regulations noted that further consideration should be given to whether gifts that are effective at death and included in the gross estate should be excepted from the special rule and reserved Regs. Sec. 20.2010-1(c)(3) for future guidance. There is significant additional discussion in the proposed regulations’ preamble regarding the two classes of transfers and how they are treated differently for estate and gift tax purposes, but the main point of the proposed regulation is to affirmatively deny the benefit of the anti-clawback rule to “includible” gifts deemed transferred at death.

The proposed regulations list the several exceptions to the special rule for transfers that are treated as testamentary transfers for estate tax purposes and thus are “includible” in the donor’s gross estate at death (Prop. Regs. Secs. 2010-1(c)(3)(i)(A) through (D), and examples under Prop. Regs. Secs. 20.2010-1(c)(3)(iii)(A) through (G), Examples 1 through 7):

1. Gifts subject to a retained life estate or subject to other powers or interests as described in Secs. 2035—2038 and 2042, regardless of whether the transfer was deductible pursuant to Sec. 2522 (charitable and similar gifts) or 2523 (gift to spouse) (Examples 4—7).
2. Gifts made by enforceable promise that are unsatisfied as of the date of death and therefore included in the gross estate (Examples 1—3; see also Rev. Rul. 84-25).
3. Gifts with a retained interest within the meaning of Regs. Secs. 25.2701-5(a)(4) and 25.2702-6(a)(1). Sec. 2701 deals with special valuation rules for transfers of certain interests in partnerships and corporations to “applicable family members,” and Sec. 2702 deals with special valuation rules for the transfer of interests in trusts. No examples are provided in the proposed regulations.
4. Transfers that would fall under Prop. Regs. Sec. 20.2010-1(c)(3)(i)(A), (B), or (C) above were it not for the transfer, elimination, or relinquishment of the interest or power that would have caused inclusion in the gross estate within 18 months prior to the donor’s date of death. This includes transactions executed by a third party (referenced in Example 1 of the proposed regulations).

The special rule will continue to apply to the transfers listed above when:

• The taxable amount of the gift is not material. This is determined at the date of transfer and applies when the taxable amount is 5% or less of the total amount of the transfer. Example 4 of the proposed regulations addresses this de minimis scenario.
• The transfer, elimination, or relinquishment, within 18 months of the donor’s date of death, was included in the original instrument of transfer, whether by death or lapse of time. (This would be the case with a grantor retained annuity trust (GRAT) or a qualified personal residence trust (QPRT) where the trust has a fixed term and should not be subject to the exception to the special rule simply because the grantor dies within 18 months following that fixed term.)

Note that the proposed regulations would apply to estates where the decedent dies on or after the publication date of April 27, 2022. It is worth noting that any completed gifts that are ultimately included in a decedent’s gross estate would also be removed from the adjusted taxable gifts reported on Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, at the value on the date of transfer under Sec. 2001(b)(2).

The following is a list of the Code sections referenced under Regs. Sec. 20.2010-1(c)(3)(i)(A) where the transfer would be excepted from the special rule and included in the above carveout provisions:

• Sec. 2035, Adjustments for certain gifts made within three years of decedent’s death;
• Sec. 2036, Transfers with retained life estate;
• Sec. 2037, Transfers taking effect at death;
• Sec. 2038, Revocable transfers; and
• Sec. 2042, Proceeds of life insurance.

Further, under Sec. 2038(a)(1), the value of the gross estate includes the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except for adequate and full consideration in money or money’s worth), by trust or otherwise, where the enjoyment thereof was subject at the date of death to any change through the exercise of a power by the decedent (alone or with another person) to alter, amend, revoke, or terminate that property transfer.

Examples

The proposed regulations include several examples that are helpful in understanding these exceptions to the special rule (Prop. Regs. Secs. 20.2010-1(c)(3)(iii)(A) through (G)). The most relevant examples are outlined below. As the proposed regulations indicate, in each example, the BEA on the date of the gift was $11.4 million, the BEA on the date of death is $6.8 million, and both amounts include hypothetical inflation adjustments. It is also assumed that the donor’s executor does not elect to use the alternate valuation date, and, unless otherwise stated, the donor never married and made no other gifts during life.

Example 1: The example deals with a situation where individual A gifts a $9 million promissory note to another individual during the TCJA period, and the full principal balance of the note remains unpaid at A’s death after the TCJA period ends on Dec. 31, 2025. Since the payment of the note would be satisfied with other assets of the estate, the initial gift is disregarded, and the note’s value is includible in the gross estate. (Effectively, the liability under the note is ignored on Form 706, and the assets that would ultimately fund the note repayment are included at full value.) This situation would meet the “Type B” exception to the special rule listed above, and as such, the BEA of only $6.8 million available at death could be used to offset that $9 million in assets.

Example 2: This example adjusts the first example by reducing A’s note to $2 million and adding in another $9 million cash gift on the same date the note was gifted. This is a fairly straightforward extension of the first example in that the $2 million note gift would essentially be ignored on the Form 706 filing, and A’s executor would be able to use the special rule to claim $9 million of BEA on the Form 706 related to the completed gift of $9 million in cash during the TCJA period.

Example 4: This example switches the facts, with individual B transferring $9 million in assets to a GRAT with the retained qualified annuity interest calculated at $8.55 million and, as such, a taxable gift value of $450,000 at the time of transfer. (This is a “Type A” exception to the special rule.) Individual B then died during the GRAT term, resulting in the recapture of the entire GRAT corpus in B’s gross estate under Regs. Sec. 20.2036-1(c)(2). The example concludes that the initial gift meets the de minimis exception of this proposed regulation since it is 5% or less (in this example, the value is exactly 5%) of the value on the date of transfer, and as such, the exception to the special rule doesn’t apply. However, the special rule isn’t relevant in this case since the gift value on the date of transfer was less than the $6.8 million BEA on the date of death.

If the facts were adjusted such that B had already given away $10.95 million of other assets prior to setting up the GRAT and thus was using the last of his $11.4 million BEA in funding it, the scenario would be more instructive. Although it is not entirely clear in the proposed regulations, under this modified fact pattern, the $450,000 would be eligible for the special rule, and it would appear the full $11.4 million BEA would be available for use on the Form 706 filing. With the trend of taxpayers implementing “zeroed-out” GRATs almost exclusively in recent years, it follows that, in practice, the de minimis rule would apply for most GRATs. Thus, the exception to the special rule under the proposed regulations really doesn’t apply to the vast majority of GRATs actually implemented.

Example 5: The facts are the same as in Example 4, except that the taxable gift increases to $1 million. As such, the 5% de minimis rule would not apply, and the exception to the special rule does apply. What is interesting in this example is that it makes a distinction between meeting the de minimis exception and not meeting it for a GRAT. This lends credence to the conclusion above that the BEA would appear to be available in the modified Example 4 fact pattern. There seems to be no reason to include Example 5 if there were no distinction between the two.

Example 6: This example adjusts the GRAT terms from Example 4 to increase the taxable gift at the time of transfer to $7 million and further states that B survives the GRAT term. The example confirms that since B outlived the GRAT term, none of the GRAT assets are includible in B’s gross estate, and the exception to the special rule would not apply. As such, the $7 million gift would qualify for the special rule, and a BEA of $7 million would be available on the Form 706 filing if B dies after Dec. 31, 2025. This conclusion seems unlikely to apply much in practice in the context of GRATs but might come into play more often with QPRTs since those normally do include a significant taxable gift component.

In addition to the GRATs, QPRTs, and promissory notes described above, a couple of other common strategies are worth mentioning as potential issues under the reach of the exception to the special rule. The first would be spousal lifetime access trusts (SLATs) that are deemed to be “reciprocal” in nature by the IRS. In theory, if the IRS were to make the argument that SLATs set up by a married couple were in fact “reciprocal,” the value of trust assets at death would be “includible” in the gross estate of the deceased spouse. The original gifts would be removed from adjusted taxable gifts, and the BEA would be based on the current level at death under the exception. This would be a terrible result for a married couple who maxed out the gifts to SLATs during the higher BEA term and then died after Dec. 31, 2025. This is just another reason to be careful in drafting and establishing pairs of SLATs in the next few years.

The second issue would apply to gifts of family limited partnership (FLP) units where the donor has retained too many strings attached or has operated the FLP as his or her personal cash funding source even after making the gifts. The potential result is essentially the same as for the SLATs: IRS inclusion of the value of the FLP units at the date of death in the deceased taxpayer’s estate and removal from adjusted taxable gifts, such that the exception to the special rule applies. Again, this is something to keep in mind when working with clients in managing the FLPs that they have established or will establish.

This discussion offers a basic understanding of these proposed regulations. Although the same basic principles would apply, this discussion does not specifically address Prop. Regs. Sec. 20.2010-1(c)(i)(3)(C) transfers under Secs. 2701 and 2702, as these complex topics are beyond the scope of this discussion. In general, the examples provided in the proposed regulations are not highly informative, and it is hoped that the final regulations will include examples that are more applicable and explain some of the distinctions more clearly.

Update of actuarial tables

On May 5, 2022, the IRS issued proposed regulations (REG-122770-18) labeled “Use of Actuarial Tables in Valuing Annuities, Interests for Life or a Term of Years, and Remainder or Reversionary Interests.” The proposed regulations’ preamble details an update of the IRS tables published for use in valuations of these types of property interests under Sec. 7520, impacting regulations across the income tax, estate tax, and gift tax regimes. Sec. 7520(c)(2) directs the Treasury secretary to update the actuarial-based tables every 10 years to take into account changes in mortality. This is the driving factor behind the issuance of this regulation.

The updated Table 2010CM is based on data from the 2010 Census and replaces Table 2000CM, which has been in place for the last 10-year cycle based on the 2000 Census. The effective date of the changes is the first day of the month following the adoption by Treasury of the proposed regulations as final regulations. Transitional rules are also provided as follows:

• For gift tax purposes, if the date of a transfer is on or after Jan. 1, 2021, and before the effective date of the final regulations, the donor has the option to use either Table 2000CM or Table 2010CM.
• For estate tax purposes, if the decedent dies on or after Jan. 1, 2021, and before the effective date of final regulations, the decedent’s executor has the option of choosing which table to use, although the same table must be used to value all interests in the same property.
• The Sec. 7520 interest rate will remain the appropriate rate for the month of the valuation date; i.e., it is not affected by the selection of the table. One exception to this rule would occur with the valuation of a charitable interest where the interest was created in January or February 2021 and the election to use the Sec. 7520 interest rate for one of the prior two months was made. In that instance, Table 2000CM must be used. Otherwise, the optional provision is available. Note that the Sec. 7520 rate was 0.4% for November 2020 and then moved to 0.6% for December 2020, January 2021, and February 2021. So, practically speaking, only gifts in January 2021 where an election was made to use the November rate would be affected. For example, this might occur where a grantor establishes a charitable lead trust in January 2021 and elected to use the November Sec. 7520 rate of 0.4% because the lower interest rate is more desirable for a lead trust.

The text of the conforming updates to numerous regulations affected by the new tables goes on for another 100 pages or so, but, practically speaking, nothing changed here other than the underlying mortality data and the resulting tables. The IRS website was already updated to include both sets of tables for each of the available uses. Presumably, third-party software services used in modeling split-interest trusts and other vehicles affected by these changes will be updated in fairly short order as well. As such, the changeover should be rather seamless for the average professional.

The more impactful change might be the update of the life expectancy tables based on the same mortality information. The Uniform Lifetime Table is the most commonly used table for retirement plan and IRA distributions, as it covers unmarried owners, married owners whose spouses are not more than 10 years younger, and married owners whose spouses are not the sole beneficiaries. The distribution factor for someone who needs to take a first required minimum distribution (RMD) at age 72 increased almost two years from 25.6 to 27.4. For a $1 million taxable retirement account, that reduces the RMD from $39,062.50 to $36,496.35. The $2,566 difference is not a huge spread, but it is another incremental opportunity to stretch out the tax deferral of the account over time.

EditorNotes

Anthony Bakale, CPA, is a tax partner with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.