Present Law
For 2011 and 2012, the estate and gift tax statutes permit cumulative tax-free lifetime transfers and transfers at death totaling $5,000,000 per person. The $5,000,000 “exemption” can be used during lifetime, or at death, or used partially during lifetime and the balance at death. The tax rate on transfers in excess of $5,000,000 is a flat 35%. Each person similarly has a $5,000,000 exemption which can be applied (during lifetime or at death) to shelter assets from generation-skipping transfer tax. The compromise that was reached in 2010 when this law was enacted was that effective January 1, 2013, the $5,000,000 is to be reduced to only $1,000,000 per taxpayer, and the top marginal estate tax rate will increase to 55%.
Using the $5,000,000 Now
A rather obvious question is: what happens if I make $5,000,000 of lifetime gifts in 2011 or 2012 and the “exemption” drops to only $1,000,000 in 2013. Will there be a tax on the “extra” $4,000,000 of gifts, and if so, when will it be due? The short answer is that no one knows. The IRS isn’t going to cross that bridge unless and until it becomes absolutely necessary. However, as detailed below (and as Donald Rumsfeld once famously told reporters, “there are known knowns, there are known unknowns, and there are unknown unknowns.” In other words, there are some things we know that we know, there are some things that we know that we don’t know, and there are some things that we’re not aware that we don’t know.
Speculation
Each year, the University of Miami sponsors a seminar for estate planners. It is probably the best known and best attended seminar in the country, and the speakers are nationally recognized. At the seminar held in January of 2011, the speakers expressed the opinion that the estate and gift tax is likely to move in one of 4 possible directions as of January 1, 2013:
The 2011 – 2012 rules will be made “permanent”, i.e., a $5,000,000 “exemption” and a 35% marginal rate;
Congress will again extend the present rules, but only for 2 years, prolonging the uncertainty;
Congress will remain hopelessly gridlocked, and as a result of the inability to agree on any changes, the present statute will be implemented and the “exemption” will fall to $1,000,000, with a 55% marginal rate, but perhaps only until one party gains control;
The estate tax will be repealed.
There is absolutely no way of predicting if one of these alternatives or some other compromise (e.g. a $3,500,000 “exemption” and a 45% marginal rate, as in 2009) will be selected. Of critical importance will be the state of the economy at the end of 2012, i.e. the need for money, and the results of the 2012 election, which will determine which party controls Congress and the White House, and whether either party controls both.
“Clawback”?
If the “exemption” is reduced to $1,000,000 (or to any number less than $5,000,000) in 2013, will there be any tax on gifts of up to $5,000,000 made in 2011 and 2012 that end up exceeding whatever the new “exemption” turns out to be. For example, if the “exemption” falls back to $1,000,000 in 2013, will someone who made a $5,000,000 gift in 2012 owe gift tax on $4,000,000? If so, will the tax be due during the donor’s lifetime or at the donor’s death? If the latter, will the tax be the responsibility of the donee(s) of the gift or the beneficiaries of the donor’s estate? The possibility of additional tax on the $4,000,000 in this example is commonly referred to by planners as a “clawback”.
Again citing the participants in the Miami seminar, the prevailing opinion seemed to be that there will be no “clawback”. In other words, if the gift wasn’t taxable when you made it, there won’t be any “retroactive” tax at a later date. This conclusion is based on an indication by Congressional staffers that no “clawback” was ever envisioned. Of course, Congress and the IRS are never predictable, so a “clawback” isn’t out of the question. Most commentators seem to be of the opinion that if there is a “clawback”, it won’t occur until the donor of the gift(s) dies. At that time, it isn’t clear (and cannot be predicted) who would be held responsible for the additional tax. However, if the done(s) of the gift and the remainder beneficiaries of the donor’s estate are different, so that it makes a difference who is responsible for the tax, the donor can resolve this issue by specifying in his/her estate plan (or at the time of the gift) who would bear the burden of any additional tax.
Conclusion
If a potential donor is economically able to consider a gift as large as $5,000,000, the uncertain state of the gift and estate tax law is no reason not to make the gift. It’s sort of “heads you win and tails you break even.” The 2011 – 2012 law could be extended (or the estate tax could be repealed), in which case there are no issues. Even if the “exemption” is reduced, the “extra” gifts in 2011 or 2012 might very well escape taxation (sort of “use it or lose it”). Finally, if the “extra” gift in 2011 or 2012 is ultimately taxed, it will almost certainly be taxed at gift tax value, so if the gifted property appreciates in value between the date of the gift and the date of the donor’s death, the donor would at the very least have gotten the appreciation out of his/her taxable estate.