The Big Bad Clawback - Does it Have Any Teeth?

The Big Bad Clawback—Does it Have Any Teeth?
September 7, 2022
By David Sloan

In the fable “The Three Little Pigs,” the Big Bad Wolf blows down the straw and stick houses built by two of the pigs, but is unable to blow down the brick house of the third pig. Similarly, in recent years, estate planners have worried about the threat of the “Big Bad Clawback,” simultaneously wondering if the “Clawback” really has any teeth and contemplating which strategies could survive such a challenge if it does.  As discussed below, the clawback issue arises because of the possibility that a large gift covered by the significantly increased lifetime exemption available under the 2017 Tax Cuts and Jobs Act (the “2017 Act”) will be “clawed back” and subject to the estate tax if the donor dies after the law sunsets on January 1, 2026.

To begin with, § 2001 of the Internal Revenue Code imposes the federal estate tax. In general, it does so by first calculating a “tentative” estate tax to be imposed on the sum of the taxable estate and the adjusted taxable gifts (“ATG”) made during the decedent’s life. In other words, the tentative tax is calculated based on essentially everything the decedent has ever gratuitously transferred, whether during life or at death.  From this tentative estate tax is subtracted a hypothetical gift tax (the “HGT”) that is equal to the gift tax that “would have been payable” if certain modifications had been made. The result of this equation is the net tentative estate tax (“NTET”) imposed by § 2001.  In this alternate universe, a larger HGT is desirable because its subtraction will result in a smaller NTET.  However, the actual estate tax is determined by applying the applicable credit amount (“ACA”) from § 2010 “against the tax imposed by § 2001.” 

The ACA is based on the applicable exclusion amount, which consists of the basic exclusion amount (the “BEA”) and the deceased spousal unused exclusion amount (the “DSUE Amount”). The 2017 Act basically doubled the BEA through 2025 (as indexed for inflation). However, when the law sunsets in 2026, the BEA will essentially be cut in half (a similar sunset was scheduled for January 1, 2013 but did not occur). For decedents who make large gifts covered by the increased BEA and then die after the sunset, the ACA available to cover the NTET could be insufficient to cover those large gifts. In other words, the unusual methodology of §§ 2001 and 2010 could result in an estate tax of up to $2 million or more for gifts that were actually covered by lifetime exemption when made. In its simplest form, this is the Clawback.

In 2010, Congress added new § 2001(g), which provided detailed rules for calculating the HGT based on the rates of tax in effect at the decedent’s death rather than the rates of tax applicable at the time of the gifts. To address the clawback issue, the 2017 Act further modified § 2001 by redesignating subsection (g) as subsection (g)(1) and by adding a new subsection (g)(2). New paragraph (2) provides that the IRS “shall prescribe such regulations as may be necessary or appropriate to carry out this section with respect to any difference between” the BEA applicable at death and the BEA applicable to lifetime gifts. As before, § 2001(b)(2) continues to provide that the HGT will be determined as if “the modifications described in subsection (g) had been applicable at the time of such gifts.”

The language of § 2001 implies that the new Regulations would modify the HGT calculation in subsection (b)(2). For example, the new Regulations under subsection (g)(2) could have followed the approach of subsection (g)(1) and provided that the HGT would be determined using the BEA in effect at death. Whether the BEA at death is higher or lower than what was available during life, the calculation of the NTET should be correct under this approach. Alternatively, for purposes of determining the NTET, it appears that the ATG amount in subsection (b)(1)(B) could have been reduced by the excess of the BEA used to cover lifetime gifts over the BEA in effect at death. Both of these approaches could have addressed the clawback through regulations issued under and affecting § 2001.

However, in November 2018, the IRS provided a special anti-clawback rule in Proposed Regulations under § 2010, which became final in November 2019 (the “Anti-Clawback Regulations” or “Special Rule”).  The Anti-Clawback Regulations are found in Regs. § 20.2010-1 in a new paragraph (c). The Special Rule provides that based on date of death tax rates, if the total credit amount allowable in computing the HGT exceeds the § 2010 credit allowable at death, “then the portion of the credit allowable in computing the estate tax on the decedent's taxable estate that is attributable to the basic exclusion amount is the sum of the amounts attributable to the basic exclusion amount allowable as a credit in computing” the HGT (emphasis added). In other words, even though the Anti-Clawback Regulations are authorized under § 2001(g)(2) for the purpose of calculating the HGT under § 2001(b)(2), the Regulations are issued under § 2010 for the purpose of modifying the § 2010 credit available at death. As a possible explanation for this choice, the Preamble to the 2018 Proposed Regulations states: “In the view of the Treasury Department and the IRS, the most administrable solution would be to adjust the amount of the credit in . . . the estate tax determination required to be applied against the net tentative estate tax” (emphasis added).

As noted by one commentator, although the Anti-Clawback Regulations focus on the present increased exemption amount and the sunset in 2026, “if Congress makes other changes in the law, particularly increases in rates or decreases in exemptions, and doesn’t focus on the potential clawback issue in the context of those changes, the generic anti-clawback regime of Section 2001(g)(1) and (2) and these regulations could produce a jigsaw puzzle of adjustments going different directions that may strain the notion of administrability cited in the preamble. But this is the type of concern that might be allayed by more examples in the final regulations.”[1]

Although a “jigsaw puzzle” of future adjustments is certainly possible, the Final Regulations do contain additional examples that provide greater clarity. In particular, the Final Regulations make clear that there will be no Clawback with respect to the DSUE Amount when a portability election has been made before the sunset. However, at the same time, the Preamble to the Final Regulations introduces new uncertainty into this area with respect to inter vivos transfers that “are treated as testamentary transfers for transfer tax purposes.” For example, certain lifetime transfers are included in the gross estate because of retained “strings” or control (e.g., under § 2036), and are therefore excluded from the category of adjusted taxable gifts in § 2001(b)(1)(B) (see flush language). The Preamble suggests that such transfers are not “bona fide inter vivos transfers” worthy of protection against “inconsistent treatment for estate tax purposes,” and states that the issue will be reserved for further consideration.

In April 2022, the IRS issued a Proposed Regulation that would add a new subparagraph (3) to the Anti-Clawback Regulations found in Regs. § 20.2010-1(c). Subparagraph (3)(i) states that the Special Rule generally “does not apply to transfers includible in the gross estate, or treated as includible in the gross estate for purposes of section 2001(b)” (emphasis added), and provides the following four non-exclusive exceptions:

• “Transfers includible in the gross estate pursuant to section 2035, 2036, 2037, 2038, or 2042,” regardless of deductibility.

These are sometimes referred to as “string provisions” and involve situations in which the donor has retained sufficient control to cause inclusion in the estate. In such cases, the Special Rule would provide an unintended “bonus” exclusion because the estate would be given the benefit of extra lifetime exclusion for a gift that was ultimately taxed at death.[2]  The exception in (A) would eliminate this unintended bonus.  

In public comments on the 2022 Proposed Regulations, the American College of Trust and Estate Counsel (“ACTEC”) has suggested that (A) be changed to the following in order to remove the focus on specific code sections:

“The decedent’s post-1976 gifts that are includible in the decedent’s gross estate.”[3]

• “Transfers made by enforceable promise to the extent they remain unsatisfied as of the date of death.”

Revenue Ruling 84-25 indicates that this type of transfer is “deemed to be includible in [the] gross estate for purposes of section 2001 of the Code,” and ACTEC notes that “this is the only example given of a transfer ‘treated as includible in the gross estate for purposes of section 2001(b).’” The explanation to the 2022 Proposed Regulation notes that this type of transfer should be an exception to the Special Rule because it is excluded from ATG (based on its inclusion in the taxable estate) and will be satisfied with assets with respect to which the donor “retained the beneficial use of or the control of the transferred property.”

ACTEC suggests that (B) be changed to the following:

“The decedent’s post 1976 gifts that consist of enforceable promises to the extent made for less than adequate and full consideration in money or money’s worth and to the extent they remain unsatisfied at death.”

• “Transfers described in § 25.2701-5(a)(4) or § 25.2702-6(a)(1)” of the Regulations.[4]

Sections 2701 and 2702 are part of Subtitle B, Chapter 14.[5] The 2022 Preamble suggests that these transfers under Chapter 14 should not qualify for the Special Rule because they are among those “that are duplicated in the transfer tax base.” In connection with certain lifetime transfers, the special valuation rules of Chapter 14 (found in §§ 2701 and 2702) value non-qualified retained interests at zero and add the missing value to the property transferred, thereby inflating ATG under § 2001(b). Meanwhile, if the retained interests are still owned at death, they will be included in the gross estate at fair market value under § 2033, resulting in a potential duplication of value for purposes of calculating the tentative estate tax.[6]  Regulations  §§ 25.2701-5 and 25.2702-6 provide mitigation rules to avoid this duplication. Although these two mitigation rules have different approaches, both operate by reducing adjusted taxable gifts. However, reducing ATG to avoid duplication of value does not remove the bonus exemption made possible by the Special Rule, which is the reason for the exception.[7]

In its comments, ACTEC asks the IRS to reconsider whether certain “transfers that are compliant with the safe-harbor provisions of Chapter 14” and “expressly protected from the zero valuation rules of section 2702” (e.g., a qualified personal residence trust (“QPRT”) or a grantor retained annuity trust (“GRAT”)) should be excepted from the protection of the Special Rule because they are qualified interests. It also points out that the retained interests described in the Regulations under §§ 2701 and 2702 are not really transfers and are not deemed to be included in the estate, but are retained interests actually included under § 2033.[8] With the foregoing in mind, ACTEC suggests that (C) be changed to the following:

“The decedent’s gifts subject to the special valuation rules of section 2701 or 2702 to the extent of any reduction in the amount on which the decedent’s tentative tax is computed under section 2001(b) pursuant to § 25.2701-5(a)(3) of this chapter or to the extent of any reduction of the decedent’s adjusted taxable gifts pursuant to § 25.2702-6(a)(2) of this chapter.”

• “Transfers that would have been described in [(A), (B), or (C)] but for the transfer, relinquishment, or elimination of an interest, power, or property, effectuated within 18 months of the date of the decedent's death by the decedent alone, by the decedent in conjunction with any other person, or by any other person.”

This provision goes beyond transfers by the decedent that trigger inclusion pursuant to the three-year rule under § 2035 and includes transfers by other people made within 18 months of death that would not be subject to the three-year rule. To shift the focus from “transfers,” ACTEC suggests that (D) be changed to the following:

“The decedent’s gifts that would have been described in [(A), (B), or (C)] but for the transfer, relinquishment, or elimination of an interest, power, or property or, in the case of clause (B), the payment of an obligation, effectuated within 18 months of the date of the decedent’s death by the decedent alone, by the decedent in conjunction with any other person, or by any other person.”

The transfers described in (A) through (D), above, are included as exceptions to the Special Rule “without limitation,” meaning that other examples may apply. However, the preamble to the 2022 Proposed Regulation also states: “The purpose of the special rule is to ensure that bona fide inter vivos transfers of property are consistently treated as a transfer of property by gift for both gift and estate tax purposes (emphasis added). As long as a lifetime transfer is bona fide and does not clearly fall within one of the four categories, it should qualify for the protection of the Special Rule. In addition, subparagraph (3)(ii) of the 2022 Proposed Regulation provides two safe harbor exceptions to the exceptions to the Special Rule.

• “Transfers includible in the gross estate in which the value of the taxable portion of the transfer, determined as of the date of the transfer, was 5 percent or less of the total value of the transfer.”

The Preamble states: “This bright-line exception to the special rule is proposed in lieu of a facts and circumstances determination of whether a particular transfer was intended to take advantage of the increased BEA without depriving the donor of the use and enjoyment of the property.”

• “Transfers, relinquishments, or eliminations described in paragraph (c)(3)(i)(D) of this section effectuated by the termination of the durational period described in the original instrument of transfer by either the mere passage of time or the death of any person.”

Keeping in mind the emphasis on bona fide inter vivos transfers as well as the two exceptions to the Special Rule exceptions, there are plenty of standard estate planning strategies that will receive the benefit of the Special Rule and not be subject to the Clawback. Of course, there is always an ebb and flow of particular strategies in the estate planning world, as the tax laws and other variables continue to change. Following the advent of § 2702, grantor retained income trusts (“GRITS”) became less desirable as estate planning strategies because of the special valuation rules under Chapter 14. Although QPRTS, GRATS, and grantor retained unitrusts (“GRUTS”) can still be structured as qualified interests that avoid the special valuation rules, even these strategies may be included in the proposed exceptions to the Special Rule and subject to the Clawback (although hopefully the IRS will make clear that they are not).

There’s an old saying in the tax law that “pigs get fat and hogs get slaughtered.”  With this in mind, if we come across some grantor retained unusual new transfer (a “GRUNT”) that doesn’t smell quite right, we should keep our distance.

Conclusion

In conclusion, like a wolf in sheep’s clothing, the Clawback isn’t as harmless as it first appears and it still has some teeth. However, like houses of brick, bona fide lifetime gifting strategies that are not testamentary in nature, do not involve enforceable promises to make gifts, do not duplicate value in the transfer tax system, and do not involve the relinquishment of related rights or powers shortly before death should hold up just fine in the storm. In contrast, like houses of sticks and straw, strategies that are testamentary in nature may get blown down.

Some have viewed fables such as “Little Red Riding Hood” and the Big Bad Wolf in terms of solar myths, in which the wolf represents the night swallowing the sun.[9] In the case of the 2017 Act, the 2026 sunset swallows the bonus exemption and the Clawback ensures that certain lifetime transfers that are testamentary in nature don’t escape, even if made before the sunset.

However, as we consider the various planning opportunities and strategies that may preserve the bonus exemption, it is worth noting that charitable giving is not the focus of the Clawback, and that the current gift and estate tax laws provide an unlimited charitable deduction, potentially making that extra exemption less important. Even with its teeth, there are many ways to defeat the Big Bad Clawback.

[1] Ron Aucutt, “Proposed ‘Anti-Clawback’ Regulations,” ACTEC Capital Letter No. 46 (November 29, 2018). This article also relies on other Capital Letters written by Ron Aucutt, particularly Nos. 55 and 57.

[2] For purposes of calculating the NTET in § 2001(b)(1), the gift would be removed from ATG in subsection (b)(1)(B) and added to the taxable estate in subsection (b)(1)(A). At the same time, the HGT calculation in subsection (b)(2) would still reflect the exclusion used for the gift. However, the Special Rule would increase the BEA at death under § 2010, thereby providing the bonus.

[3] Presumably ACTEC would retain the qualification that this rule applies regardless of deductibility.

[4] In its comments, ACTEC notes that this reference should probably be to § 25.2702-6(a)(2), dealing with testamentary transfers, rather than to 6(a)(1), dealing with inter vivos transfers.

[5] With respect to transfer taxes generally, Chapters 11, 12, and 13 of Subtitle B respectively relate to the estate tax, the gift tax, and the generation-skipping transfer tax. Meanwhile, §§ 2701 and 2702 are the first two of the four code sections that make up Chapter 14, which is the other key chapter of the Code specially dealing with transfer taxes (there is also a Chapter 15, which has only one section and deals with expatriates).

[6] Although ATG in § 2001(b)(1)(B) does not include gifts that are includible in the gross estate, the previously transferred interests to which extra value was added are not included in the gross estate, meaning that the inflated value stays in ATG. At the same time, the fair market value of the retained interests at death is included in (b)(1)(A), resulting in duplicated value for purposes of calculating the tentative estate tax.

[7] In comments on the 2018 Proposed Regulations, one commenter suggested that the § 2701 exception to the Special Rule could be handled in the mitigation rule for § 2701 by reducing the amount of the reduction to adjusted taxable gifts. However, as noted above, the mitigation rules generally don’t affect the exclusion amount, and the connection between the two is mainly coincidental. In fact, to completely eliminate the bonus exemption made possible under the Special Rule for a § 2701 transfer might actually require increasing adjusted taxable gifts (e.g., if the duplicated amount were less than the initial value of the transfer). A similar analysis would apply to the mitigation rules under § 2702. In declining to adopt the suggested approach, the Preamble to the 2022 Proposed Regulations reaches a similar conclusion, stating: “Thus, while a reduction in the amount of adjusted taxable gifts eliminates amounts duplicated in the transfer tax base, it neither changes the existence of the transfer nor frees up the credit allocable to that transfer.” The approach taken by the new Proposed Regulations is much cleaner and targets the real source of the extra credit problem, which is the way the Special Rule increases the § 2010(c) credit, not the Chapter 14 mitigation rules.

[8] Although the retained interests are included under § 2033, they are not gifts that are includible in the gross estate, and therefore they would not be covered by ACTEC’s proposed language for (A), above.

[9] See https://en.wikipedia.org/wiki/Big_Bad_Wolf.