The gift and estate tax exemption allows individuals to make cumulative gifts during their lifetime up to a certain amount without incurring gift taxes. If any of the exemption amount goes unused during their lifetime, the remaining amount is applied against transfers made at death without incurring estate taxes. The Tax Cuts and Jobs Act (TCJA) temporarily increased the gift and estate tax exemption amount from $5 million to $10 million (indexed for inflation) from 2018 through 2025. Beginning in 2026, the exemption is scheduled to revert to the pre-TCJA level of $5 million.
However, the increase as well as its temporary nature left taxpayers with questions. On November 23, 2018, the Department of the Treasury and IRS addressed four key concerns, resulting in one proposed regulation to help clarify this provision of the new tax law.
1. If a taxpayer has consumed all of his exemption before 2018, how will the increase in the exemption apply to gifts made in 2018 through 2025?
The increased exemption amount available from 2018 through 2025 will be applied against gifts made from 2018 through 2025. The increase will not be applied against any pre-2018 gift in which the taxpayer paid gift tax. In other words, even if a taxpayer had consumed all of his exemption amount before 2018 and was paying gift tax on transfers in excess of that amount, he will be able to exclude from gift tax the first $5 million of transfers made between 2018 and 2025 before paying gift tax again.
2. What happens if the same taxpayer from question 1 above dies in any year from 2018 through 2025?
Similar to the previous result, the increased exemption amount will not be reduced by pre-2018 gifts in which the taxpayer paid gift tax. In other words, if a taxpayer consumed all of his exemption as a result of pre-2018 gifts, did not make any gifts after 2017, and died somewhere in 2018 through 2025, the decedent taxpayer still would be able to exclude $5 million from his estate for estate tax purposes. Without an increase in the exemption, the decedent taxpayer would have paid estate taxes on the full value of his taxable estate, as the exemption would have been fully consumed by his lifetime gifts.
3. What happens if a taxpayer makes gifts from 2018 through 2025 in excess of the pre-2018 $5 million exemption but less than the temporary $10 million exemption — and that taxpayer makes a gift after 2025 when the exemption has reverted to $5 million? Do the exempt gifts made from 2018-2025 become taxable?
The guidance states that the gift tax liability in any one year will be limited to the tax calculated on the total gifts made in that same year. In other words, gifts made from 2018 through 2025 that were exempt from gift tax will not become taxable when the exemption lowers in 2026.
While questions one through three were clarified in the preamble to the proposed regulations, the preamble also confirms the gift and estate tax statutes already in place arrive at the above conclusions. As a result, no regulations are being proposed to address these areas.
4. What happens if a taxpayer makes gifts from 2018 through 2025 in excess of the pre-2018 $5 million exemption but less than the temporary $10 million exemption — and the taxpayer dies after 2025 when the exemption has reverted to $5 million?
A literal application of the estate tax statutes would, in effect, retroactively eliminate the benefit of the increased exemption amount available from 2018 through 2025. Congress recognized this issue and in the TCJA granted regulatory authority to the Treasury Department to address situations in which differences exist between the exemption amount applicable to the decedent’s gifts and that applicable to the decedent’s estate. As a result, the proposed regulations state that the benefit of the temporary increase in the exemption would not be retroactively eliminated. In other words, gifts that were exempt from gift tax when made will continue to be exempt when calculating the taxpayer’s estate tax liability. In this situation, all of the taxpayer’s taxable estate but none of the taxpayer’s gifts would be subject to estate tax.
To fully understand why regulatory action is needed in this situation, it is important to review the estate tax calculation. The estate tax is calculated using a five-step approach.
- Compute a tentative tax on the entire taxable estate plus total taxable gifts made after 1976;
- Compute a hypothetical gift tax on all post-1976 gifts using the estate tax rate in effect in the year of death and the exemption available in the year of the gift;
- Subtract the number from step 2 from the number in step 1 (this step has the effect of removing from the estate tax computation any gifts in which gift tax was paid);
- Compute the tax that would be due on the exemption amount in the year of death (this includes the $5 million or $10 million exemption, as applicable depending on the year of death, plus any unused exemption from a deceased spouse);
- Subtract the number from step 4 from step 3 to determine the ultimate estate tax.
The interaction between steps two and four is causing gifts in excess of $5 million, which were exempt from gift tax when made, to be subject to the estate tax at death due to a reduction in the exemption amount. To prevent this from occurring, the IRS and Treasury have proposed to increase the amount calculated in Step 4. If this proposed regulation is finalized as written, and absent any future legislative changes related to the gift and estate tax, taxpayers will be able to use the additional $5 million exemption knowing they will obtain the full benefit of the temporary increase.
If you have exhausted your pre-TCJA gift and estate tax exemption of $5 million, now is a good time to review options for using the additional $5 million exemption to transfer additional wealth to the next generation without incurring gift or estate tax. Timing is critical, as the additional exemption amount is only available through the end of 2025.
Please contact a member of your service team, or contact Michael Boncher at email@example.com or Alane Boffa at firstname.lastname@example.org for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.