On April 26, 2022, the IRS issued proposed regulations that may impact some gifting strategies taxpayers have been using in order to use the increased estate exclusion amount before it is set to decrease in 2026.
Background. In 2017, Congress amended Internal Revenue Code (IRC) § 2010(c)(3) to increase the estate exclusion amount to $10 million per person, adjusted annually for inflation. The increase is set to expire on January 1, 2026, which will result in the estate exclusion amount reverting back to $5 million per person, adjusted annually for inflation. In 2019, the IRS issued final regulations establishing a “special rule” that ensures that a donor’s estate will not be taxed on completed gifts that used the increased estate exclusion amount, even if the donor passes away after the estate exclusion amount has reverted to the lower amount.
This “special rule” did not address a distinction made in the internal revenue code between “adjusted taxable gifts” that are completed gifts not includible in the donor’s gross estate for estate tax purposes, and completed gifts that are treated as testamentary transfers includible in the donor’s gross estate for estate tax purposes.
New Proposed Regulations. The new proposed regulations adjust the “special rule” to only apply to completed gifts that are not includible in the donor’s gross estate for estate tax purposes. By making this distinction, the IRS effectively limits some planning opportunities that taxpayers have taken advantage of in order to use the increased estate exclusion while still retaining an interest in the assets that have been gifted.
One planning opportunity that many have taken advantage of is gifting a fully enforceable loan where the donor promises to pay the donee an amount sufficient to use the increased estate exclusion. By making a gift of a loan, it enables the donor to make payments over time with a balloon payment due at death, instead of making a large gift of cash or other property immediately. The proposed regulations specifically highlight this planning opportunity, indicating that it would fall under the exception to the “special rule” and therefore only the estate exclusion available at the donor’s death would be applied. Here's the example:
Assume that when the basic estate exclusion amount was $11.4 million ($10 million adjusted for inflation), a donor gifted an enforceable $9 million promissory note to their child (i.e. a promise to pay their child $9 million). This transfer constituted a completed gift of $9 million.
On the donor’s death, the assets that are to be used to satisfy the note are part of the donor’s gross estate, with the result that the note is treated as includible in the gross estate for purposes of IRC § 2001(b). Thus, the $9 million gift is excluded from adjusted taxable gifts in computing the tentative estate tax under IRC § 2001(b)(1).
Nonetheless, if the donor dies on or after January 1, 2026, the credit to be applied in computing the donor’s estate tax is the credit based upon the basic estate exclusion allowable as of the donor’s date of death ($6.8 million).
Another planning opportunity that many have taken advantage of, and that the IRS has consistently scrutinized, is the use of family-limited partnerships. The IRS has been known to challenge transfers of discounted limited partnership interests by arguing that the donor retained control over the family limited partnership. Where the IRS has been successful in these challenges, the value of the transferred limited partnership interest is included in the donor’s gross estate for estate tax purposes. The “special rule” of the proposed regulations would apply to these situations, giving the IRS a greater incentive to challenge family limited partnership interest transfers.
The proposed regulations can be found here.
Conclusion. The IRS is still seeking comments on these proposed regulations, and it is possible that there will be adjustments prior to the regulations becoming final. If you have taken advantage of the above strategies, or a gifting strategy that is similar, we encourage you to reach out to your HBK tax advisor to discuss the impact these proposed regulations may have on your overall estate plan.