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Estate Planning and Clawback Rules

Updated: Mar 17, 2021

According to U.S. law, all U.S. citizens regardless where they live have an obligation to pay taxes on their worldwide income. In addition, upon ones death, they will be liable to pay FEDERAL (and sometimes State) Estate Tax (ET).

For gifts made or estates of decedents dying between Dec. 31, 2017, and before Jan. 1, 2026, the TCJA increased the amount to $10 million, also indexed for inflation after 2011 (Sec. 2010(c)(3)(C)).

Thus, the amount for 2017 was $5.49 million and, for 2018, $11,180,000 (rising to $11.4 million in 2019).This means that Americans can exclude this amount of assets from their taxable estate. In other words, if you die and leave $15,000,000 worth of investments and other assets to your heirs and haven't given any taxable gifts, only $3,820,000 of this will be subject to estate tax. What's more, this exclusion amount is per person. If you are married and are both US citizens, the exclusion is doubled. However this provision is due to sunset at the end of 2025, after which the ET is assumed to be lowered.

The question is what happens if one gifts the full amount under the available gift tax exemption today, but the amount exempt from estate tax reverted to some lesser number prior to his death. Will the Internal Revenue Service (IRS) consider for ET purposes, the estate and gift tax exemption amount applicable at the time of the gift or at the time of the person’s death.

The statutory sunset of the higher basic exclusion amount and reversion to the lower amount could, in effect, retroactively deny taxpayers who die after 2025 the full benefit of the higher exclusion amount applied to previous gifts if part of the gift in effect be taxed anyway in the estate tax calculation. This scenario has sometimes been called a “clawback” of applicable exclusion amount.

The Act was not entirely clear about how the use of the exemption for gifting will be reconciled with a lower exemption at death in 2026 and beyond. Congress had recognized the need to address this potential issue by authorizing the U.S. Department of the Treasury to issue guidance in IRC section 2001(g) (2);

(g) Modifications to tax payable.—

(2) MODIFICATIONS TO ESTATE TAX PAYABLE TO REFLECT DIFFERENT BASIC EXCLUSION AMOUNTS.—The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out this section with respect to any difference between—

(A) the basic exclusion amount under section 2010(c)(3) (estate tax exclusion amount) applicable at the time of the decedent's death, and;

(B) the basic exclusion amount under such section applicable with respect to any gifts made by the decedent.

Basically, congress directed the IRS to prescribe “necessary or appropriate” regulations with respect to any difference between the basic exclusion amount in effect at the time of any gifts made by the decedent and at the donor’s death.

On November 20, 2018, the IRS issued proposed regulations concerning various effects of the increase in gift and estate tax exclusion amounts that are in effect from 2018 through 2025 and the post-2025 decrease in those amounts back to pre-2018 levels.

To address concerns that an estate tax could apply to gifts exempt from gift tax by the increased basic exclusion amount (BEA), the proposed regulations provide a special rule that allows the estate to compute its estate tax credit using the higher of the BEA applicable to gifts made during life or the BEA applicable on the date of death.

Notably, the proposed regulations would provide that taxpayers that take advantage of the increased exclusion amounts will not be adversely affected by the post-2025 decrease. As a result, people planning to make large gifts between 2018 and 2025 can do so without being concerned that they will lose the tax benefit of the higher exclusion level once it decreases.

I will conclude with an example:

A (unmarried), made cumulative post-1976 taxable gifts of $9 million, all of which were sheltered from gift tax by the cumulative total of $10 million in basic exclusion amount allowable on the dates of the gifts. A dies after 2025 and the basic exclusion amount on A’s date of death is $5 million.

Because the total of the amounts allowable as a credit in computing the gift tax payable on A’s post-1976 gifts (based on the $9 million basic exclusion amount used to determine those credits) exceeds the credit based on the $5 million basic exclusion amount applicable on the decedent’s date of death, the credit to be applied for purposes of computing the estate tax is based on a basic exclusion amount of $9 million, the amount used to determine the credits allowable in computing the gift tax payable on the gifts made by A and no tax would be owed.

If, in the example, the gift had been $12 million instead of $9 million, the estate tax credit would be computed as if the basic exclusion amount was $10 million (the exclusion amount until end of 2025), and the remainder would be payable gift tax.

The content of this article is intended to provide a general guide to the subject matter and is not a substitute for legal consultation. Specific legal advice should be sought in accordance with the particular circumstances.

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