[Okay, we are not dummies, but this is a very tough issue to follow in its entirety for most of us.]
Until recently, the term “clawback” did not mean much to estate planners and tax attorneys. Those with some knowledge of bankruptcy law were familiar with the term – it involves the forced return of assets to a debtor (and thus the bankruptcy estate and potentially to creditors) to void fraudulent transfers and transfers made shortly before the filing of bankruptcy.
With Bernie Madoff, the term reached broader use – relating to the risk that investors with Madoff who received from Madoff more than their original investment with him over the years may be required to return such excess amounts for redistribution to Mr. Madoff’s victims.
The term is now part of the estate tax lexicon. This use relates to whether persons who make large gifts that use some or all of the current $5 million plus unified credit equivalent amount, will be subject to estate taxes on all or a portion of those gifts at their later death if the unified credit equivalent amount is then lower than the exemption amount used for lifetime gift giving. If the answer is yes, the current advantages for making large gifts in 2012 before the exemption amount reverts to $1 million in 2013 are materially diminished (although not eliminated), and planning for who will pay the later increased estate tax will need to be undertaken.
The problem is one of statutory interpretation, involving provisions that are not well-understood nor precisely drafted. This posting will summarize the problem, list the principal arguments put forth for and against clawback, and provide my own thoughts. This will be an abridged version, so further reading may be needed if a more thorough understanding of these issues and arguments is needed – otherwise, this post could go one for 20 pages (which I am sure most of you would not want to read and I would not want to write).
THE PROBLEM. The problem comes out of Code §2001(b) which tells us what the total amount of estate tax will be, so let’s copy it here:
(b) The tax imposed by this section shall be the amount equal to the excess (if any) of—
(1) a tentative tax computed under subsection (c) on the sum of—
(A) the amount of the taxable estate, and
(B) the amount of the adjusted taxable gifts, over
(2) the aggregate amount of tax which would have been payable under chapter 12 with respect to gifts made by the decedent after December 31, 1976, if the provisions of subsection (c) (as in effect at the decedent's death) had been applicable at the time of such gifts. (emphasis added)
The first part of the problem is Code §2001(b)(1)(B) – in computing the estate tax, we add back to the taxable estate all of the adjusted taxable gifts made by the decedent during his or her lifetime. We then compute a tentative tax on this combined total.
Since gifts taxes were applicable to the lifetime gifts, Code §2001(b)(2) provides for a reduction in the estate tax for those gift taxes. Taxpayers will want the amount of the gift taxes to be as high as possible under this computation, since these gift taxes reduce the estate tax payable. A corollary to that desire is that taxpayers will want the unified credit amount applicable to the lifetime gifts to be as LOW as possible, so as to crank up higher the gift tax amount.
The second part of the problem is that this gift tax computation is a “constructive” computation of gift taxes – not an actual computation of those amounts as they applied at the time of the gift. To drill down further, the ultimate question is whether, in computing the constructive gift taxes at the time of the gift, should the unified credit amount be the amount of unified credit as it existed under law in the year of the gift, or in the year of death. As noted above, in circumstances where the unified credit amount is high in the year of the gift (e.g., 2011 or 2012), and low in the year of death (2013 or thereafter, under current law), taxpayers want to use the unified credit amount that applies in the year of death. This cranks up the constructive gift tax, and thus reduces the estate tax payable.
The gist of the problem is that §2001(b)(2) tells us to compute the gift tax “which would have been payable under chapter 12 [i.e., the gift tax chapter],” but does not tell us which year to use for the unified credit portion of that computation. Compounding the problem is that in prior tax years, it has been the IRS’ interpretation that in making this computation, it is the unified credit amount applicable in the year of the gift that applies. If correct, this means that when a donor later dies, and substantial 2011 or 2012 gifts are added into his or her estate tax computation, the constructive gift tax reduction applied to the tentative estate tax will be low – and there will not be a corresponding high unified credit amount available for estate tax purposes to offset this enhanced tax. Thus, in effect, this statutory analysis recaptures some of the gift tax that avoided tax at the time of the gift under the then-available unified credit, as estate tax due at death.
ARGUMENTS AGAINST CLAWBACK. The principal arguments against clawback are:
a. Congress did not intend clawback, and this intent should override any contrary statutory interpretations.
b. The sunset provisions of EGTRRA treat the $5 million unified credit amount as having never existed, once 2013 rolls around. If that is the case, how can such a large credit amount be used for computing gift taxes for a post-2012 estate tax return?
c. Clawback is inconsistent with the entire unified gift and estate tax regime – such regime is not built to tax prior gifts at death that were exempt from tax at the time of the gift.
d. Code §2001(b)(2) provides that the use of tax rates in effect at the decedent’s death (through the reference to Code §2001(c) and the parenthetical right after it) applies to the constructive gift tax computation – thus, unified credit amounts at death should likewise apply.
ARGUMENTS IN FAVOR OF CLAWBACK. The principal arguments in favor of there being a clawback are:
a. The statute says what it says and has been interpreted in this manner for many years, both in the instructions to the Form 706 and other Treasury pronouncements. This supports the use of the unified credit amount as it existed at the time of the gift.
b. There has been no change to the language of the law that merits a change in interpretation.
c. Congress made changes to Code §2001(b)(2) and (g) in December 2010, but did not change this particular portion. Thus, Congress intended to continue the current application of the law.
d. Gift tax computations are made on a calendar year basis, and thus it is nonsensical to apply a unified credit amount from a different year (the year of death) to the year of the gift.
e. To apply the sunset provisions of EGTRRA to avoid clawback would require, from a consistency basis, that other unlikely results would be mandated, such as a fair market value date-of-death basis in all assets sold after 2012 even though EGTRRA provides for a reduced basis in many circumstances for those that elected out of estate tax in 2010, and loss of GST exemption to gifts made in 2011-2012 in excess of a $1 million exemption.
f. The reference to estate tax rates at the time of death under Code §2001(c) does not mean that unified credit amounts at that time should also apply, since the credit amounts arise under a different Code section.
MY THOUGHTS. For what they are worth, here are my thoughts and observations.
a. Hopefully, Congress will enact the provisions of the Sensible Estate Tax Act of 2009, which would statutorily fix this problem, and avoid clawback. However, this doesn’t help us in regard to present planning, since its passage at this time is speculative. If Congress materially increases the unified credit at death for 2013 and beyond, this will also reduce or eliminate the problem.
b. The statute and its prior interpretation are clear – thus, on its face it appears clawback does apply. Further, that Congress thought it was necessary to Code §2001(b)(2) to add a specific modification to direct the use of rates in effect at the decedent’s death (through the reference to Code §2001(c) and the parenthetical right after it) in computing the constructive gift tax amount, implies that the rest of the constructive gift tax amount is undertaken using exemptions and other legal provisions in effect at the time of the gift. Otherwise, a reference to rates in effect at death would not have been needed.
c. The “sunset” arguments perhaps may persuade the IRS or the courts that clawback does not apply, but uncertainty remains.
d. Thus, while it is possible that the IRS or the courts may adopt a ‘no clawback’ interpretation, and indeed that would probably be the correct result as a matter of Congressional intent, a reasonable risk of clawback remains.
e. Nonetheless, even with clawback, the benefits of a larger 2012 gifts remain. These include (1) enhanced GST exemption for generation-skipping gifts or gifts to trusts that may later have a skip, (2) shifting of appreciation in gifted assets to third parties after the gift that would not otherwise occur (which may provide future estate tax savings), and (3) in many circumstances overall tax savings may still result, even with clawback. Thus, while clawback at worst may reduce benefits of 2012 gifting, enough remain that it may still make sense in many situations.
f. Estate tax apportionment agreements as part of the gift transaction may be in order, so that if increased estate taxes occur later, the proper beneficiaries bear the burden of the enhanced tax. Such agreements may come with their own issues, however.