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SEE THE CIRCULAR 230 DISCLAIMERS APPENDED TO THE CONCLUSION OF THIS WASHINGTON REPORT.

In our Bulletin No. 11-06, we discussed, among other things, the increased gift, estate and generation-skipping transfer tax exemptions available in 2011 and 2012 under the Tax Relief, Unemployment Insurance Authorization and Job Creation Act of 2010 (“TRA 2010”). We then stated that “[e]ven though the GST tax exemption may be reduced after 2012, the allocation of up to $10 million (per married couple) of gift and GST tax exemption in 2011 and 2012 will not be taken away or reduced after 2012 . . .” While it is technically correct that the gift and GST exemptions are set for 2011 and 2012, commentators have noted that there is a possibility that gifts made during those years may be added back to the base on which the estate tax is computed after 2012, thus potentially subjecting those tax exempt 2011 and 2012 gifts to the estate tax. This possibility is referred to here as the “claw back” scenario.

The confusion arises because, since the 1976 Tax Reform Act (when the estate and gift tax exemptions were first “unified”) the concept of “adjusted taxable gifts” has been used to compute the amount of Federal estate tax due on the taxable estate. In essence, the amount of post-1976 taxable gifts is added to the taxable estate, the estate tax is computed on the total amount, and the gift tax previously paid is then backed out of the computation. The purpose of the addition of adjusted taxable gifts to the computation is to increase the estate tax brackets for the taxable estate so that they are equal to the brackets that would have applied if the taxable gifts had been made at death (thus preventing two bracket runs). However, because, for the first time since the unified system was adopted, the exemption for lifetime gifts may be higher than the exemption for estate tax purposes, there exists the potential for subjecting prior tax exempt gifts to estate tax.

For example, assume Parent makes taxable gifts in 2012 of $5 million, using up his exemption so that no gift taxes are due, and dies in 2013 with a taxable estate of $10 million. Assume further that the unified exemption amount in 2013 for estate and gift tax purposes has decreased to $3.5 million, and the rate has increased to 45%. The estate tax on the $10 million taxable estate should be approximately $4.5 million, assuming a 45% rate in 2013. Does the $1.5 million of previously exempted taxable gifts now generate an extra estate tax? Under the current Form 706 (Federal Estate Tax Return), the computation of the estate tax due may answer this question in the affirmative, depending on how the calculation is made – i.e., by using the year of the gift to compute the “gift tax paid or payable” vs. the year of death, as follows:

Example 1 Gift Tax Payable Based on Date of Gift:

Line Item Amount

* Per § 2001(c) as in effect in 2012: $155,800 +35% of excess of $5 million over $500,000

Example 2: Gift Tax Payable Based on Date of Death:

Line Item Amount

* Per § 2001(c) as in effect at 2013: $780,000 + 45% of excess of $5 million over $2 million

The difference in tax between the two examples, or $400,000, illustrates the potential effect (in the first example), of a “claw back” tax of $1.5 million of the $5 million gift into the decedent’s estate if the credit for tax on prior gifts is computed at the rate applicable on the date of the gift.

Some commentators have argued, based on their interpretation of TRA 2010 and the intent of Congress, as evidenced in new Internal Revenue Code § 2001(g) and current law (Code § 2001(b)(2)), as well as on the purpose of the “adjusted taxable gifts” add-back (i.e., to prevent a double run at the brackets, which are now essentially flat) that the rates in effect at the date of death should be applied and that there is no “claw back” in effect under TRA 2010. However, at least now this is far from clear. It may require a legislative technical correction, or, merely a clarification to the current Form 706.

AALU has heard others contend that Congress did not intend that gifts made during 2011 and 2012 would be subject to the estate tax in 2013 and thereafter. This interpretation is further bolstered by the Revenue Estimates for Title III of TRA 2010 (prepared by the Joint Committee on Taxation), which do not increase after 2012 in the significant amounts that one would expect to see if it were the intention to subject 2011 and 2012 gifts to the estate tax. (The increases that do appear may be the result of expected income tax collections from the heirs of decedents whose estates elected carryover basis in 2010.)

In the meantime, what should producers tell their clients (all subject of course to consultation by clients with their legal advisors)? Certainly, the risk of subjection of 2011 and 2012 gifts to the estate tax should be disclosed. However, producers should also disclose the following:

First, even assuming that the claw back applies, those donors who elect to make use of their $5 million gift (and GST) tax exemptions in 2011 and 2012 should be no worse off than those who die without having made gifts in those years. In either case, the gifts, whether made or foregone, will be included in the decedent’s estate, and will be subject to tax at whatever rates and exemptions are then in effect.

Second, there are significant benefits to using the $5 million exemption in 2011 and 2012, including the fact that the appreciation on the gifted assets will not be subject to “claw back,” even if the gifts themselves are. In addition, the ability to leverage gift transfers through sales of assets – e.g., to grantor trusts – or purchases of life insurance should enable donors to transfer the appreciation on assets far in excess of the $5 million exemption ($10 million per couple).

Finally, there is a chance that the $5 million per person unified exemption will become permanent (or, in any event, subject to serial extensions), and/or that transition relief in the computation of the tax on prior taxable gifts in the event that the $5 million exemption is reduced (which will likely be the result of legislation, and thus will provide an opportunity for enacting such relief) will be afforded.

In order to comply with requirements imposed by the IRS which may apply to the Washington Report as distributed or as re-circulated by our members, please be advised of the following:

THE ABOVE ADVICE WAS NOT INTENDED OR WRITTEN TO BE USED, AND IT CANNOT BE USED, BY YOU FOR THE PURPOSES OF AVOIDING ANY PENALTY THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE.

In the event that this Washington Report is also considered to be a “marketed opinion” within the meaning of the IRS guidance, then, as required by the IRS, please be further advised of the following:

THE ABOVE ADVICE WAS NOT WRITTEN TO SUPPORT THE PROMOTIONS OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED BY THE WRITTEN ADVICE, AND, BASED ON THE PARTICULAR CIRCUMSTANCES, YOU SHOULD SEEK ADVICE FROM AN INDEPENDENT TAX ADVISOR

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