Blog What if Federal Gift and Estate Tax Exclusions Are Lowered?

By Cowles Liipfert & Don Wells

The federal gift tax and estate tax exclusion was doubled from $5 million to $10 million, indexed for inflation, by the Tax Cuts and Jobs Act of 2017, which is currently scheduled to expire on January 1, 2026.  Taking into consideration indexing for inflation, the total exclusion for 2024 is $13.61 million per person, or $27.22 million per married couple.

With the high exclusion under the Tax Cuts and Jobs Act, very few people are currently required to pay federal estate tax.   

The Tax Cuts and Jobs Act of 2017 was passed during the Trump administration, and the Biden administration proposed significant cuts to the exclusion, which many anticipated to go back to the pre-Trump level of $5 million, indexed for inflation, which would be $6.805 million in 2024, if applicable this year, or $13.61 million for a married couple. 

Generally, a decedent’s taxable estate is computed by combining the assets constituting his or her taxable estate at death with the total of his or her lifetime taxable gifts (i.e. – gifts in excess of annual exclusion gifts).  The decedent’s gross taxable estate is then calculated on that amount, reduced by a credit equal to the date-of-death estate tax exclusion amount.  If any federal gift tax has actually been paid by the decedent on any taxable lifetime gifts, then a credit is allowed for gift taxes paid.

If a decedent made $1 million in taxable gifts and thereby used $1 million of his or her lifetime gift tax exclusion to avoid paying gift tax on those gifts, the full $1 million would be added to the decedent’s taxable estate on Form 706, Federal Estate Tax Return, but the decedent’s estate would be entitled to the full amount of the estate tax exclusion on the date of death, unreduced by the gift tax exclusion which had been used during the decedent’s lifetime. 

If that decedent’s assets were worth $8 million on the date of death, and if he or she had made $1 million in lifetime taxable gifts, then his or her total taxable estate would be $9 million, and the estate would be entitled to the full estate tax exclusion applicable on the date of death.  Under the $13.61 million exclusion in effect in 2024, there would be no estate tax payable at the decedent’s death.

If, however, the estate tax exclusion amount is lowered to pre-Tax Cut and Jobs Act levels by the time of a decedent’s death, and if the adjustment for inflation was $2.5 million at that time, the date-of-death exclusion amount would be $7.5 million ($5 million base amount plus $2.5 million adjustment for inflation).  If we further assume that the taxable estate totaled $9 million under the facts described in preceding paragraph, then there would be federal estate tax on the difference between the gross taxable estate of $9 million and the date-of-death exclusion of $7.5 million – a difference of $1.5 million, since the lifetime taxable gifts would be less than the date-of-death exclusion.

In contrast, let us suppose that the decedent had made taxable lifetime gifts utilizing his or her full $13.61 million gift tax exclusion for 2024, prior to his or her death, instead of the $1 million gifts assumed in our example above, and further suppose that the estate tax exclusion was later lowered to $7.5 million on the date of death.  Would the $6.61 million difference between the gift tax exclusion of $13.61 million reported on the decedent’s gift tax returns and $7.5 million date-of-death estate tax exclusion be included in the decedent’s taxable estate?

In November 2019, the IRS published final “Anti-Clawback” Regulations, Reg. Sec. 20.2010-1(c), under which the $6.11 million difference between gift tax exclusion at the time of the gifts and the date-of-death estate tax exclusion would not be “clawed back” into the decedent’s taxable estate.  Instead of adding all lifetime taxable gifts to the decedent’s taxable estate on Form 706, the Federal Estate Tax Return, the difference between the higher gift tax exclusion at the time of the gift and the lower estate tax exclusion on the date of the decedent’s death would not be included in the decedent’s taxable estate.  Under the above example, $6.11 million of the lifetime gifts (the difference between the $13.61 million gift tax exclusion and the $7.5 million date-of-death exclusion) would not be added into the decedent’s taxable estate.  That is, there would be no gift or estate tax on those gifts totaling $6.11 million which had been made under the gift tax exclusion, which were in excess of the date-of-death estate tax exclusion.

The Anti-Clawback Regulations are applicable if the Tax Credit and Jobs Act of 2017 expires in 2026 or if the exclusion is reduced by legislation prior to that deadline. 

The Anti-Clawback Regulations are applicable only when the value of total lifetime taxable gifts exceeds the date-of-death exclusion.  Taxable gifts totaling less than the date-of-death exclusion are added back, in computing the decedent’s taxable estate, but gifts in excess of that amount, up to the gift tax exclusion at the time of the gift, are not included in the decedent’s taxable estate. 

Even if the Anti-Clawback Regulations were not applicable, there could be some tax advantages to making lifetime taxable gifts totaling less than the date-of-death estate tax exclusion.  For example, (1) income earned on gifted assets is taxable to the donee, instead of the donor, and that income is not included on the donor’s federal estate tax return; and (2) post-gift capital appreciation on the gifted property, if any, also is not included on the donor’s estate tax return.  However, there would be no advantage under the Anti-Clawback Regulations.

Not many taxpayers can afford to make lifetime gifts which are large enough to take advantage of the Anti-Clawback Regulations, but those few taxpayers who can and do make such gifts could reap large transfer tax benefits for their families. 

One possibility is that a person who has a very short life expectancy might make large lifetime gifts to take advantage of the Anti-Clawback Regulations, which they might otherwise not consider because of fear of outliving their assets.  With only weeks or months to live, this might not be much of a concern.  If that person is unable to act for himself or herself at that time, and if that person has a durable power of attorney which expressly permits his or her Agent under the power of attorney to make gifts, then the Agent should consider making those large gifts on behalf of that person.

If you’ve heard of a “three-year rule” under which “deathbed” gifts, i.e. – gifts made within three years prior to a decedent’s death, were disregarded for estate tax purposes, that is no longer a problem!  That rule was the law at one time, but the law has been changed.  At the time of the three-year rule, federal gift taxes and federal estate taxes were separate tax systems.  Estate taxes were payable only on assets either owned at death or subject to certain powers retained by a decedent.  To keep taxpayers from avoiding estate taxes by making gifts shortly before death, Code Section 2035 at that time treated all transfers made within three years of death as “gifts in contemplation of death,” and disallowed those gifts in the calculating a decedent’s taxable estate.

Congress later adopted an integrated gift/estate tax system, whereby all taxable lifetime gifts are added to a decedent’s taxable estate for estate tax purposes, whether or not made within three years prior to death.  Consequently, the Anti-Clawback Regulations make no distinction between deathbed gifts or gifts made years earlier, and large deathbed gifts could reap the benefits of the Anti-Clawback Regulations, even if the estate tax exclusion is lowered after the date of the gift and before the death of a decedent.    

Another tip: If a husband and wife want to make large lifetime gifts to their children and/or grandchildren – to take advantage of the Anti-Clawback Regulations – but they are not able to make large enough gifts to utilize both spouses’ full exclusions – they should not make joint gifts, which would be deemed to be one-half each.  It would be more tax-efficient for the gifts to be from one spouse only, to enable the gifts by that spouse to utilize his or her gift and estate tax exclusion as much as possible, without splitting the gifts with the other spouse.   

To consult with one of our firm’s attorneys, please call 336-725-2900.