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Clawback of the Gift Tax

Why taxpayers need to decide whether to make large gifts in 2011 or 2012.

September 2011
by Marvin Hills/The Tax Adviser

The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, P.L. 111–312 (the 2010 Tax Relief Act), was signed into law on December 17, 2010. It increases the lifetime gift tax exclusion from $1 million (as it had been since 2002) to a full $5 million for 2011 and 2012. Although this allows taxpayers to now make additional lifetime gifts of at least $4 million during 2011 or 2012 without paying gift tax, there is concern that the Internal Revenue Service (IRS) will attempt to assess either an additional gift tax or extra estate tax if the lifetime exclusion is subsequently reduced. The reduction in the exclusion might occur if:

  • Congress enacts a new law providing that the gift tax exclusion is lower after 2012 (for example, setting it at $3.5 million as recommended in President Barack Obama’s 2012 budget proposal); or
  • Congress does nothing and the 2010 Tax Relief Act provisions are allowed to sunset.

This sunset rule exists because the 2010 Tax Relief Act (§§304 and 101(a)(1)) amends Section 901 of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), P.L. 107–16, to provide that “the Internal Revenue Code of 1986 ... shall be applied and administered to years, estates, gifts and transfers [after December 31, 2012,] as if the provisions and amendments in [this act] had never been enacted.” The effect of the sunset would be that the lifetime exclusion for gift tax purposes would revert to the 2002 level of $1 million and the top tax rate would become 55 percent.

Therefore, because of the uncertainly about what Congress may or may not do in the future, a taxpayer who is considering making a $5 million tax-free gift in 2011 or 2012 might be concerned that either an additional gift tax will be assessed at the time a subsequent gift is made or an additional estate tax will be imposed upon death. For example, if a $5 million gift is made in 2012 but the exclusion is reduced to $1 million in 2013, will the taxpayer owe additional tax on the excess $4 million? Overall, the answer is likely to be different for gift tax purposes than it is for estate tax purposes. This item shows why a “clawback” of additional gift tax on a 2011 or 2012 gift will not be triggered by a subsequent gift in 2013 or after, whereas there could be a “recapture” on a large 2011 or 2012 gift in the form of additional estate tax at death.

Observation: Practitioners are divided on whether the clawback in the form of additional estate tax will occur for deaths after 2012 as described below if the EGTRRA estate tax provisions are allowed to sunset. Under this scenario, some argue that “would have been payable” in Sec. 2001(b)(2) means “would have been payable if EGTRRA were never enacted,” which would avoid the clawback problem. This point is discussed in more detail below.

Overview

As a broad concept, the gift and estate taxes are both computed by adding the current transfer amount (either a gift value or assets held at death) to prior-year gifts and computing a tentative tax on the total, then reducing that tentative tax by the tax on the prior gifts, leaving the tax owed on the current transfer. The difference is how the unified credit that was used to offset the prior gifts is factored into those calculations.

More specifically, gift tax is basically computed as: (1) the tentative tax (per Sec. 2502(a)(1)(A)) on the total of current-year and prior lifetime gifts, reduced by (2) the tentative tax (per Sec. 2502(a)(1)(B)) on only the prior-year gifts, further reduced by (3) the Sec. 2505 unified credit that has not been previously used. On the other hand, the estate tax is computed as (1) the tentative tax (per Sec. 2001(b)(1)) on the total of the lifetime and at-death transfers, reduced by (2) the gift tax checks that “would have been payable” on the lifetime gifts (per Sec. 2001(b)(2)), further reduced by (3) the full unified credit allowed by Sec. 2010(c)(1) for the year of death (regardless of how much was used during one’s lifetime). Therefore, the distinction is that the subtraction at item 2 for gift tax is a “tentative tax” (before any offset for unified credit), whereas item 2 of estate tax is the actual amount payable (after all unified credits have been used). Note that all these tax calculations, including those involving prior-year gifts, are computed by substituting the current-year tax rates (per Secs. 2505(a) for gift tax and 2001(g) for estate tax) instead of the rates actually applicable in the prior year.

Gift Tax

The best way to fully understand the impact of this distinction is to apply the specific Code sections using hypothetical examples and calculate the actual tax liability.

This article has been excerpted from The Tax Adviser. View the full article here.