Who’s Afraid of CLAWBACK?

Lifetime gifts of between $1 million and $5 million during 2012 escape gift tax. But the way the Tax Code is now written, if the donor dies in 2013 or later, the applicable exclusion amount reverts to $1 million. As a result, lifetime gifts of over $1 million are “clawed back” into the transfer tax system without the protection of a $5 million applicable exclusion amount, and presto, there’s an estate tax on what had been free of gift tax. Congress could fix this, and even seems to want to, but ongoing legislative dysfunction will darken the chances.  I’ve run some numbers on this. Here’s what I found.

Worst Case Scenario

The worst that happens is that a transfer tax on a lifetime gift is paid at death instead of at the time of the gift. So, at first blush, the specter of clawback is really, at worst, neutral.

The Upside

In the time between the date of the gift and the donor’s death, post-gift appreciation is removed from the taxable estate.

Lifetime gifts, including those subject to clawback, can reduce estate taxes in other ways. For example:

  • If the gift is to a grantor trust, the donor could be paying the income taxes, without being treated as making additional gifts.
  • If the gift is of a fractional interest in property, that might create valuation discounts.
  • Gifts to grantor trusts can pave the way for a later sale of property to that trust.

The Downside

But there’s more to the story that we should be aware of. Clawback gifts can have a downside that’s easy to miss.

Estate tax apportionment might get skewed in a clawback situation. The recipients of the lifetime gifts won’t suffer the cost of a gift tax, and they might not suffer any of the clawback estate tax, either, under state tax apportionment statutes. If those receiving the lifetime gift aren’t the estate’s beneficiaries in the same proportions, then someone else picks up the estate tax bill.

The estate’s beneficiaries won’t be happy. Therefore, it may be wise for the donor to enter into an agreement with the donees whereby they agree to pay over to the estate an appropriate share of the estate tax in the event of clawback.

Possibly, such an agreement also decreases the taxable value of the gift by the actuarial present value of the increase in estate tax caused by clawback. In Succession of McCord v. Commissioner, No. 03-60700, CA-5 (Aug. 22, 2006), the U.S. Court of Appeals for the Fifth Circuit held that the contingent estate tax payable under Internal Revenue Code Section 2035 reduced the value of the gift in the net gift computation. The court rejected the IRS’ argument that the contingent estate tax liability was speculative. Thus, it’s possible for an estate tax to reduce the value of a taxable gift. And while the estate tax in McCord was contingent on death occurring within three years of the date of gift, the clawback effect isn’t contingent under the law as it’s now written. Taking possible Congressional action into account would require speculation.

Without such an agreement, the estate tax bite on the estate might be so great as to bankrupt it.

In addition to a potential negative effect on estate beneficiaries, states could also suffer a revenue loss. States that would have a pickup tax if the pre-Economic Growth and Tax Relief Reconciliation Act estate tax system comes roaring back (as it’s scheduled to do after 2012) would get less with a lifetime gift. That’s because the state death tax credit is based on the taxable estate without regard to lifetime gifts.

Let’s hope Congress fixes the problem. In the meantime, don’t let clawback stop the gifts; just be aware of what you should do differently.