Clawback of the gift tax.

• Author: Hills, Marvin D.

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 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 actj 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%.

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)(l)(A)) on the total of current-year and prior lifetime gifts, reduced by...