September 6, 2012

Estate and Gift Tax: Clawback

The future of the estate and gift tax is muddled to put it mildly. If no legislation is enacted before the close of the year, the estate and gift tax exemption limits for 2013 will revert back to the $1M threshold. For this year, 2012, the current estate and gift tax limit is $5.12M. In case you are curious as to the $120,000 part of the figure, when the estate tax was modified in 2010, it set the limit at $5M for 2011 and pegged it to inflation for 2012.

The estate and gift tax system are linked together so as to prevent somebody from giving away their entire estate before they die. This is known as the unified credit. If a person uses up a portion of their gift tax exemption, assuming they decline to pay the gift tax, this lowers the amount of their estate tax exemption. If a person never uses any of their lifetime gift tax exemption their full estate tax exemption remains intact.

Due to the rather large estate and gift tax exemption for 2012, $5.12M, this intrigues many an affluent parent, uncle, grandparent, etc. who wish to take advantage of the current scheme and gift a substantial amount of property to a lucky soul or souls tax-free. However, due to potential fluctuations in the estate and gift tax system, this attractive option is not as clear-cut as it appears. The following example illustrates this point.

Assume Mary Magnanimous is a wealthy widow worth $4.12M living in San Francisco, CA. She decides to gift $3.12M in cash to her neighbor James Joyce in 2012. Fast forward to January 2013 and Mary passes away with an estate worth $1M. According to the estate and gift tax regime, lifetime gifts are added to the value of a decedent's estate. This is where the term "clawback" comes from. In other words, gifts made during the decedent's life are brought back into equation when valuing the decedent's estate. The problem for 2013 is what happens to a person like Mary Magnanimous who decides to gift an amount in excess of $1M, will the gift be subject to clawback or is the gift not subject to clawback? In other words, when Mary passes away in 2013, will her estate be valued at $1M or will it be valued at $4.12M. The former figure represents Mary's estate value excluding her $3.12M gift in 2012 whereas the latter represents Mary's estate value including her $3.12M gift in 2012.

The application or non-application of clawback is enormous. If clawback is applied, her estate would be subject to a 35% estate tax on the amount above $1M, namely $3.12M, which results in a tax of $1.092M owed to everybody's friend, the IRS. Conversely, if clawback is not applied,  Mary's estate tax would be $0 because her estate of $1M would not exceed the exemption amount, $1M.    

Unfortunately, there is no definitive answer as to whether clawback will occur or not. I have read online that clawback will occur automatically. This is simply not true. Don't believe everything you read on the Internet! More importantly though, the current law does not directly address the clawback issue. 

We just have to wait and see what happens to the estate and gift tax system for 2013. The very likely scenario is that a lame-duck session of Congress will take up the issue in December. That is what happened in 2010 when the estate and gift tax was set to revert back to $1M in 2011 as well.