United States: Anti-Abuse Exception To The Anti-Clawback Regulations (T.D. 9884)

2022-13

A. Introduction

Section 11061 of the Tax Cuts and Jobs Act amended IRC Sec. 2010(c)(3) to provide that, for decedents dying after and gifts made after December 31, 2017 and before January 1, 2026, the basic exclusion amount (BEA) is increased from $5 million to $10 million as adjusted for inflation. This increase will be referred to as the "increased BEA." On January 1, 2026, the increased BEA will be reduced to $5 million as adjusted for inflation.

In November 2019, final regulations were published under IRC Sec. 2010 (T.D. 9884, 84 Fed. Reg. 64995) to address cases described in the final regulations under IRC Sec. 2001(g)(2). These regulations created a special rule (§20.2010-1(c)) to apply in cases where the credit against the estate tax attributable to the BEA is less at the date of death than the sum of the credits attributable to the BEA allowable in computing gift tax payable under IRC Sec. 2001(b)(2) with regard to a decedent's lifetime gifts; the portion of the credit against the net tentative estate tax attributable to the BEA is based on the sum of the credits attributable to the BEA allowable in computing gift tax payable for a decedent's lifetime gifts. The purpose of the rule is to ensure that a donor's estate is not taxed on completed gifts that, as a result of the increased BEA, were free of gift tax when made. The Preamble to the final regulations provides that further consideration would be given to the issue of whether gifts that are not true inter vivos transfers but rather are includible in the gross estate should be excepted from the special rule.

Proposed regulations, discussed below, dealing with the "further consideration" were published on April 27, 2022 (87 Fed. Reg. 24918). Organizations, including the American College of Trust and Estate Counsel (ACTEC) and the New York State Bar Association (NYSBA), filed comments dealing with the proposed regulations and those comments are also discussed below. See Tax Analysts Document No. 2022-24477 (ACTEC) and Tax Analysts Document No. 2022-22566 (NYSBA). We will quote from each of these two submissions.

B. "Anti-Abuse" Addition

The proposed regulations insert a new subparagraph (3) in the anti-clawback paragraph (c) that was added to Treas. Reg. §20.2010-1 in 2019. Prop. Reg. §20.2010-1(c)(3)(i) sets forth exceptions from the special anti-clawback rule for "transfers includible in the gross estate, or treated as includible in the gross estate for purposes of section 2001(b)."

A heading in the Preface of the proposed regulations "Explanation of Provisions" states:

Pursuant to sections 2010(c)(6) and 2001(g)(2) of the Code, the proposed regulations would add proposed §20.2010-1(c)(3) to provide an exception to the special rule for transfers that are includible in the gross estate or are treated as includible in the gross estate for purposes of section 2001(b), including for example gifts subject to a retained life estate or subject to other powers or interests as described in sections 2035 through 2038 and 2042 of the Code regardless of whether the transfer was deductible pursuant to section 2522 or 2523, gifts made by enforceable promise, and other amounts that are duplicated in the transfer tax base, including a section 2701 interest within the meaning of §25.2701-5(a)(4) and a section 2702 interest within the meaning of §25.2702-6(a)(1). The exception to the special rule also would apply to transfers that would be described in the preceding sentence but for the transfer, elimination, or relinquishment within 18 months of the donor's date of death of the interest or power that would have caused inclusion in the gross estate, effectively allowing the donor to retain the enjoyment of the property for life. In addition to transfers, eliminations, or relinquishments by the donor, examples include the elimination, by a third party having the power to eliminate or extinguish the interest or power, of the interests or powers that otherwise would have resulted in inclusion of transferred property in the donor's gross estate; the payment of a gift made by enforceable promise as described in Rev. Rul. 84-25, supra; and the transfer of a section 2701 interest within the meaning of §25.2701-5(a)(4) or a section 2702 interest within the meaning of §25.2702-6(a)(1). For purposes of the preceding sentence, such transfers, eliminations, and relinquishments include those effectuated by the donor, the donor in conjunction with any other person, or by any other person, but do not include those effectuated by the expiration of the period described in the original instrument of transfer, whether by a death or the lapse of time.

The special rule, however, would continue to apply to transfers includible in the gross estate when the taxable amount of the gift is not material, that is, the taxable amount is 5 percent or less of the total amount of the transfer, valued as of the date of the transfer. Compare section 2037(a)(2), excluding from the gross estate property subject to a reversionary interest where the value of such interest immediately before death is 5 percent or less of the value of the transferred property; and section 2042(2), excluding from the term "incidents of ownership" reversionary interests where the value of such interest immediately before death is 5 percent or less of the value of the life insurance policy. See also section 673(a), treating the grantor as the owner for income tax purposes of any portion of a trust in which the grantor's reversionary interest exceeds 5 percent of the value of such portion as of the date of inception of that portion of the trust. This bright-line exception to the special rule is proposed in lieu of a facts and circumstances determination of whether a particular transfer was intended to take advantage of the increased BEA without depriving the donor of the use and enjoyment of the property.

The proposed exception to the special rule may be illustrated by the following example. Assume that when the BEA was $11.4 million, a donor gratuitously transferred the donor's enforceable $9 million promissory note to the donor's child. The transfer constituted a completed gift of $9 million. On the donor's death, the assets that are to be used to satisfy the note are part of the donor's gross estate, with the result that the note is treated as includible in the gross estate for purposes of section 2001(b). Thus, the $9 million gift is excluded from adjusted taxable gifts in computing the tentative estate tax under section 2001(b)(1). Nonetheless, if the donor dies after a statutory reduction in the BEA to $6.8 million, the credit to be applied in computing the estate tax is the credit based upon the $6.8 million of the BEA allowable as of the date of death.

To summarize, the quoted discussion deals with several subjects. First, transfers included in the gross estate pursuant to IRC Secs. 2035-2038 and 2042. Second, gifts by an enforceable promise. Third, certain Chapter 14 transfers. Fourth, a new 18-month transfer rule. In the next section, the ACTEC submission refers to these four subjects as Clauses (A)-(D).

C. ACTEC Comments

The ACTEC submission states in part:

1. Transfers to Which the Special Rule Does Not Apply

Section 20.2010-1(c)(3)(i) states that the Special Rule does not apply to "transfers includible in the gross estate, or treated as includible in the gross estate for purposes of section 2001(b) . . . ." It then lists in clauses (A) through (D) four different types of transfers that are said to be either includible or treated as includible.

As a technical matter, the Special Rule does not apply to transfers. Instead it applies to the amounts attributable to the basic exclusion amount allowed as a credit in computing the gift tax payable on the decedent's post 1976 gifts. We suggest that the exception focus clearly on the amounts that the Special Rule applies to by changing the introductory language of section 20.2010-1(c)(3)(i) to read as follows:

Except as provided in paragraph (c)(3)(ii) of this section, the special rule of section (c) of this section does not apply to amounts attributable to the basic exclusion amount allowable as a credit in computing the gift tax payable on those of the decedent's post-1976 gifts that are listed below:

Clause (A) deals with transfers actually includible in the gross estate. It lists transfers that are includible under sections 2035 through 2038 and section 2042. Clause (A) makes no mention of sections 2033, 2039, or 2041.

Presumably, transfers includible under these three sections are intended to fit within the Proposed Exceptions. It is unclear why they are omitted from the list.

We suggest Clause A be changed to read as follows:

"(A) The decedent's post-1976 gifts that are includible in the decedent's gross estate."

Clause (B) addresses transfers made by enforceable promise to the extent unsatisfied at death. This is the only example given of a transfer "treated as includible in the gross estate for purposes of section 2001(b)." When a lifetime transfer is included in a decedent's gross estate, the flush language of section 2001(b) excludes it from the decedent's adjusted taxable gifts. Neither the Code nor the regulations contains any provision that treats a lifetime gift as includible in the gross estate of the decedent if it is not actually includible under another provision of the Code. Revenue Ruling 84-25, however, does treat the amount of an enforceable gratuitous promise made by a decedent that is unsatisfied at death as "deemed to be includible in [the Decedent's] gross estate for purposes of section 2001 of the Code." The purpose of the deemed inclusion is to eliminate the amount of the gift from the decedent's adjustable taxable gifts in order to avoid a double transfer tax on the same amount. If the IRS thinks there are other types of transfers "deemed includible," it would be helpful if examples were provided.

If there are no additional examples, we suggest Clause (B) be changed to read as follows:

(B) The decedent's post 1976 gifts that consist of enforceable promises to the extent made for less than adequate and full consideration in money or money's worth and to the extent they remain unsatisfied at death.

Clause (C) deals with transfers described in §§25.2701-5(a)(4) and 25.2702-6(a)(2). Neither of those sections actually describes a transfer that is deemed includible in the gross estate for purposes of section 2001(b). Section 25.2701-5(a)(4) describes a retained interest in an entity if that retained interest was valued using the special valuation rules of section 2701 in connection with the decedent's transfer or deemed transfer of another interest in that entity that was valued using the special valuation rules of section 2701. Section 25.2702-6(a)(2) describes a retained interest, includable in a decedent's gross estate, in transferred property if that retained interest was valued at zero in connection with the decedent's lifetime transfer of another interest in that property.

If the decedent owns at death interests described in Clause C, the interests are actually included rather than merely deemed included in the decedent's gross estate. They are included under section 2033. When these types of interests are includible in a decedent's gross estate, a mechanism is needed to avoid imposing an estate tax on values that have already been treated as taxable gifts. The mechanism chosen in the section 2701 regulations is to reduce the amount on which the decedent's tentative estate tax is computed by an amount equal to the lesser of (i) the amount by which section 2701 caused an increase in the decedent's taxable gifts and (ii) the amount by which the estate tax value of the interest exceeds the section 2701 value of that interest at the time of the original transfer. The mechanism chosen in the section 2702 regulations is the reduction of the decedent's adjusted taxable gifts by an amount equal to the lesser of (i) the amount by which section 2702 caused an increase in the decedent's taxable gifts and (ii) the increase in the decedent's gross estate caused by the inclusion of that interest in the decedent's gross estate.

In order to clarify the manner in which the Proposed Exceptions apply to interests described in §§25.2701-5(a)(4) and 25.2702-6(a)(2), we suggest Clause (C) be changed to read as follows:

(C) The decedent's gifts subject to the special valuation rules of section 2701 or 2702 to the extent of any reduction in the amount on which the decedent's tentative tax is computed under section 2001(b) pursuant to §25.2701-5(a)(3) of this chapter or to the extent of any reduction of the decedent's adjusted taxable gifts pursuant to §25.2702-6(a)(2) of this chapter.

Clause D describes transfers that would have been described in any of clauses (A) through (C) but for the elimination, for any reason, of an interest, power, or property effectuated within 18 months of the decedent's death. To shift the focus from the decedent's "transfers," we suggest Clause D be changed to read as follows:

(D) The decedent's gifts that would have been described in paragraph (c)(3)(i)(A),(B), or (C) but for the transfer, relinquishment, or elimination of an interest, power, or property or, in the case of clause (B), the payment of an obligation, effectuated within 18 months of the date of the decedent's death by the decedent alone, by the decedent in conjunction with any other person, or by any other person.

2. General Policy Concerns

Both the Preamble to the Final Regulations and the Preamble to the Proposed Regulations contain several references to the types of transactions that the Proposed Regulations intend to exclude from the Special Rule. The Preamble to the Final Regulations stated that further consideration would be given to the issue of whether gifts that are not "true inter vivos transfers" should be excepted from the Special Rule. Similarly, the Preamble to the Proposed Regulations distinguishes between "completed gifts that are treated as adjusted taxable gifts," and "completed gifts that are treated as testamentary transfers," and it also refers to a "bona fide" inter vivos gift versus a gift of property that is includible in the Grantor's gross estate.

We appreciate that the underlying intent of the Proposed Regulations is to prevent situations in which a donor can lock in the increased exemption without having surrendered the benefits of ownership with respect to the gifted asset. It may, however, not be appropriate to treat gifts that are in a form expressly authorized under the provisions of section 2702 as subject to Reinstated Clawback. For example, even if a donor executes a gift transaction that is intended to result in a complete termination of the donor's interest in the transferred property within a period of time expected to occur before the donor's death and that is expressly protected from the zero valuation rules of section 2702, such as a Qualified Personal Residence Trust ("QPRT") or a grantor retained annuity trust ("GRAT"), the Proposed Regulations would treat the gift as subject to Reinstated Clawback if the donor died before the retained interest had terminated. From a policy perspective, these safe-harbor transactions may not be the types of transfers to which an "anti-abuse" regulation should be applied. Therefore, we recommend that the IRS reconsider whether transfers that are compliant with the safe-harbor provisions of Chapter 14 of the Code should be subject to Reinstated Clawback.

For example, suppose in June 2022 a 65-year-old donor who has previously used $7,000,000 of BEA transfers to a five-year QPRT a personal residence worth $6,638,678. The taxpayer's gift will be reduced by the value of two retained rights under section 2702 the right to live in the residence for five years, and the five-year reversionary right to receive the return of the residence if the donor dies within the five-year term, with the resulting gift being $5,060,000. If the donor died within the five-year term of the retained interests, the personal residence would be included in the taxpayer's estate and the gift of $5,060,000 would be excluded from the donor's adjusted taxable gifts by section 2001(b). The gift to a QPRT is not the equivalent of a testamentary transfer. When making the gift, the taxpayer relied on the reduction in the value of the gift by the two retained rights as specifically provided for by section 2702. Treating the donor's gift as subject to Reinstated Clawback may be inappropriate. Instead, we suggest that consideration be given to allowing the donor the benefit of the increased BEA available at the time of the original gift. We recognize, however, that it may be appropriate to treat a transfer to a QPRT in which rights to a personal residence are retained for a term exceeding the donor's life expectancy as equivalent to a testamentary transfer. For example, if the 65-year-old donor in this example created a QPRT with a 35-year term, the 2022 gift would be approximately $35,000. If the taxpayer died within the 35-year term, we agree that Reinstated Clawback treatment would be appropriate.

We also note that retained interests causing estate tax inclusion ("strings") do not always provide financial value to the donor. For example, a donor who retains control over the timing of enjoyment of transferred property has retained a string sufficient to cause the inclusion of the transferred property in the donor's gross estate under section 2038. Yet, this string creates no possibility that the donor will regain the benefit of the transferred property. To take the position that every retention of a string by a taxpayer who has gratuitously transferred property should result in a conclusion that the donor has not made a bona fide gift, may make the Proposed Exceptions too broad. In many of these cases, the donor has suffered a financial detriment, by forgoing the use of the BEA and increased BEA (which will not be restored for many years), thereby foreclosing other planning opportunities. The potential loss of exemption is a very real detriment to the taxpayer.

3. Clarification Regarding Treatment of Notes Outstanding at Death and Examples 1, 2, and 3

The Proposed Regulations specifically address transfers made by enforceable promise to the extent they remain unsatisfied as of the date of death. We recommend modification of the examples to make it clear that they apply only to decedent's enforceable promises and only to the extent the promises were not made for adequate and full consideration in money or money's worth.

Section 20.2010-1(c)(3)(i)(B) of the Proposed Regulations is consistent with the reasoning set forth in the Preamble only if the transfer of an enforceable promise was a completed gift under section 2511. If the promise was a completed gift, it would be treated under Revenue Ruling 84-25 as includible in the donor's gross estate (rather than as an adjusted taxable gift). The reasoning set forth in Revenue Ruling 84-25 relies on several key assumptions:

1. The promise to pay is enforceable under state law;

2. The promise to pay is made by the donor (i.e., the donor is the obligor);

3. The transfer of the enforceable promise to pay was gratuitously made and, therefore, was a completed gift;

4. The assets available to satisfy the promise to pay are part of the donor's estate; and

5. The promise to pay remains unsatisfied (or partially unsatisfied) at the time of the donor's death.

The facts set forth in Examples 1 and 2 satisfy all of these assumptions other than the enforceability requirement. The example would be clearer if the first sentence were changed to insert the word "enforceable" before the words "Promissory note." The gratuitous transfer of an unenforceable promise to pay would not have been a completed gift, and, therefore, would not have used any of individual A's BEA. Furthermore, the Examples' conclusions that the "note" is treated as includible in the gross estate for purposes of section 2001(b) is not technically correct. The note is an obligation, not an asset to be included in the estate. We suggest that the word "note" be changed to "gift." This change would be consistent with the conclusion reached in Revenue Ruling 84-25.

The wording of §20.2010-1(c)(3)(i)(B) of the Proposed Regulations is not limited to "gratuitous" transfers or transfers "other than for money or money's worth" and we believe it should be. A plain reading of §20.2010-1(c)(3)(i)(B) suggests that it would apply to any transfer made by enforceable promise to the extent it remains unsatisfied as of the date of death. Consider, however, a decedent who had purchased assets in exchange for a promissory note having the same fair market value as the purchased assets. The value represented by the note was transferred to the seller by an enforceable promise to pay, but the decedent received adequate and full consideration in money or money's worth in exchange for the promise. The modified language we suggest in section 1 of these Comments would provide the requested clarification.

* * *

5. The Eighteen Month Rule

Section 20.2010-1(c)(3)(i)(D) of the proposed regulations (Clause (D)), referred to below as the "18-month rule" provides that the Special Rule does not apply to:

Transfers that would have been described in paragraph (c)(3)(i)(A), (B), or (C) of this section but for the transfer, relinquishment, or elimination of an interest, power, or property, effectuated within 18 months of the date of the decedent's death by the decedent alone, by the decedent in conjunction with any other person, or by any other person.

The Preamble to the proposed regulations explains:

The exception to the special rule also would apply to transfers that would be described in the preceding sentence but for the transfer, elimination, or relinquishment within 18 months of the donor's date of death of the interest or power that would have caused inclusion in the gross estate, effectively allowing the donor to retain the enjoyment of the property for life. In addition to transfers, eliminations, or relinquishments by the donor, examples include the elimination, by a third party having the power to eliminate or extinguish the interest or power, of the interests or powers that otherwise would have resulted in inclusion of transferred property in the donor's gross estate; the payment of a gift made by enforceable promise as described in Rev. Rul. 84–25, supra; and the transfer of a section 2701 interest within the meaning of §25.2701–5(a)(4) or a section 2702 interest within the meaning of §25.2702–6(a)(1). For purposes of the preceding sentence, such transfers, eliminations, and relinquishments include those effectuated by the donor, the donor in conjunction with any other person, or by any other person, but do not include those effectuated by the expiration of the period described in the original instrument of transfer, whether by a death or the lapse of time.

The 18-month rule appears inconsistent with the policy decisions that Congress made when enacting section 2035 and changing it over the years. For example, while section 2035 originally utilized a contemplation of death rule, after much litigation as to the intent of decedents, Congress substituted a 3-year bright line test for the contemplation of death rule. The 18-month rule seems to override Congress' choice of the 3-year period.

Further, section 2035 captures only transfers and relinquishments made by the decedent. In contrast, the proposed 18-month rule would include actions taken by persons other than the decedent, i.e., actions that are outside the scope of section 2035. Similarly, section 2035 has a specific exception for a transfer that qualifies as a "bona fide sale for an adequate and full consideration," while the 18-month rule does not appear to contain such an exception.

For example, building on the fact pattern in Example 7, if a trustee who is not a related or subordinate party with respect to C, as defined in section 672(c), terminates the GRIT within 18 months before C's death, the 18-month rule would apply to the GRIT, yet section 2035 would not include that property in C's estate and Revenue Ruling 95-58 would not impute the trustee's powers to C for purposes of section 2036. Explanation of the effect of the 18-month rule in this circumstance would be helpful.

The discussion of the 18-month rule is limited by comparison to the comments of the NYSBA quoted below.

D. Comments of NYSBA Tax Section

The comments refer to the temporary increased BEA as the "bonus BEA," the BEA that remains available to an estate after the bonus BEA expires as the "standard BEA" and to transfers that fail to preserve the bonus BEA as "targeted gifts." The principal recommendations are summarized as follows:

1. Treasury and the Service consider whether the portability regulations should be revised so that targeted gifts may not be used to lock in deceased spousal unused exclusion ("DSUE") before an individual remarries and survives a second spouse.

2. The final regulations clarify whether a targeted gift can absorb the standard BEA, even if it cannot preserve bonus BEA.

3. The final regulations clarify that some transfers are treated as targeted gifts, even if they are neither includible in the gross estate nor treated as includible.

4. Treasury and the Service consider whether gifts that the donor later borrows back should, in some cases, be treated as targeted gifts.

5. The final regulations clarify that the retention of a qualified payment right within the meaning of Section 2701(c)(3) does not cause a transfer to be treated as a targeted gift.

6. The final regulations replace or supplement the 5% rule set forth in Prop. Reg. §20.2010-1(c)(ii)(A) with a provision that that would permit application of the anti-clawback rule in cases where the donor retains no more than a qualified retained interest within the meaning of Section 2702(b).

7. The final regulations eliminate the disparities that would arise under the Proposed Regulations in the treatment of transfers, relinquishments, or eliminations of interests, powers or property prior to death, and instead adopt a uniform and consistent rule.

The summary is followed by a detailed discussion of each of the recommendations. We will quote in full from some of them.

II. EFFECT OF TARGETED GIFTS ON THE USE OF DSUE AND STANDARD BEA

The final anti-clawback rule contains two ordering principles, which together determine how much bonus BEA, if any, remains available at death. First, if an individual inherits deceased spousal unused exclusion or "DSUE" from a deceased spouse under the portability rules of Section 2010(c), then the DSUE is deemed to be applied before any BEA. Thus, an individual must exhaust any DSUE before any BEA (whether bonus BEA or standard BEA) can be used. Second, the BEA at death is only enhanced if the BEA applied against a decedent's taxable gifts exceeds the standard BEA. For example, if a decedent made no more than a $6.8 million taxable gift when the BEA was $11.4 million, and later dies in a year when the BEA is $6.8 million, only $6.8 million of BEA is available at death. The $6.8 million of BEA shields the lifetime gift from estate tax but does not shield any portion of the taxable estate passing at death. The $4.6 million difference between the $11.4 million of BEA available when the gift was made and the $6.8 million gift amount is lost. Effectively, the standard BEA is applied before any bonus BEA can be preserved.

Given the foregoing two ordering principles, any anti-abuse rule should include guidance on what portion, if any, of a decedent's total applicable exclusion amount may be used by targeted gifts. As discussed below, the Proposed Regulations take a different approach to targeted gifts that, for gift tax purposes, use up DSUE versus targeted gifts that use up standard BEA. We recommend that Treasury and the Service either adopt a consistent approach or, if the disparity is retained in the final regulations, explain the rationale for the difference in treatment.

Effect of targeted gifts on DSUE. The Proposed Regulations directly address, in an example, whether a targeted gift may use up any DSUE inherited by the donor from a deceased spouse. Specifically, in Example 3 of the Proposed Regulations, a decedent who had inherited $2 million of DSUE made a $2 million taxable gift in the form of a promise that was enforceable under state law. The decedent also made a $9 million gift of cash (presumably, without retaining an interest) a "few days later." Although both gifts were made when the bonus BEA was $11.4 million, the decedent dies in a year when the BEA is $6.8 million. The example concludes that the enforceable promise gift successfully absorbed all of the decedent's $2 million of DSUE, so that the later cash gift preserves $9 million of BEA in the computation in the estate tax. In other words, a targeted gift — such as a gift of an enforceable promise — can use up DSUE even though it cannot use up any BEA.

Conceptually, Example 3 takes the same approach to clawback that Treasury and the Service previously adopted in implementing the portability regime of Section 2010(c). As noted in our Prior Report, because a donor may only use DSUE inherited from his or her "last deceased spouse," a donor's estate could, without a special rule to the contrary, be deprived of DSUE that the donor had used up prior to remarrying and surviving a second spouse. Treas. Reg. §20.2010-3(b) prevents this result by adding to the applicable exclusion amount available at death any DSUE that was actually used by a decedent prior to surviving a second spouse.

In other words, the portability regulations have their own anti-clawback rule (referred to herein as the "portability anti-clawback rule"), which addresses the effect of gifts that use up DSUE before it is lost upon remarriage and survival of a second spouse. The portability anti-clawback rule — which is not to be confused with the anti-clawback rule of Treas. Reg. §20.2010-1(c) that deals with the effects of declines in the BEA — does not distinguish between targeted and non-targeted gifts. Thus, any form of taxable gift, including a gift of an enforceable promise, can successfully preserve DSUE before it is lost following the remarriage and survival of a second spouse.

Example 3 of the Proposed Regulations applies the approach of the portability anti-clawback rule to the anti-clawback rule of Treas. Reg. §20.2010-1(c). That is, just as a targeted gift can preserve DSUE before an individual remarries and survives a second spouse, so, under Example 3, can a targeted gift absorb DSUE for purposes of determining whether a decedent preserved any bonus BEA for use at death. Only after DSUE is exhausted must an individual avoid making a targeted gift in order to successfully lock in bonus BEA.

Given how the portability anti-clawback rule operates, it is understandable that the Treasury and the Service would propose to have the anti-clawback rule of Treas. Reg. §20.2010-1(c) operate in the same fashion. That is, for the sake of consistency, Example 3, like the portability anti-clawback rule, concludes that a targeted gift can use up DSUE for purposes of determining how much bonus BEA, if any, is available at the donor's death. That said, the result in Example 3 is not compelled by the portability regulations. Conceivably, the final regulations could provide that a targeted gift fails to use up DSUE for purposes of determining how much bonus BEA is available at death, even if a targeted gift, under the portability anti-clawback rule, can preserve DSUE for use by the estate of a decedent who remarried and survived a second spouse. Perhaps it would be difficult to rationalize why the consequences of targeted gifts should be different in each context, but a difference in results would be logically possible.

Moreover, apart from conceptual consistency with the portability regulations, it is difficult to see why the Proposed Regulations adopt a favorable rule in the case of the use of DSUE. As explained in the preamble to the Proposed Regulations, Treasury and the Service have concluded, as a matter of policy, that targeted gifts are not legitimate techniques for preserving the applicable exclusion amount before it expires. Yet without explanation in the preamble, the Proposed Regulations propose a rule that favors the use of targeted gifts solely for purposes of determining how DSUE is used. Rather than carve out an exception for DSUE, Treasury and the Service may wish instead to adopt a consistent policy on targeted gifts. Specifically, Treasury and the Service may wish to consider proposing modifications to the portability anti-clawback rule that would prevent the use of targeted gifts to lock in DSUE before remarriage and survival of a second spouse. With those changes made, the final anti-abuse rule regulations could likewise provide that a targeted gift that uses up DSUE for gift tax purposes is nevertheless disregarded for estate tax purposes when determining how much bonus BEA is available to a donor's estate. To illustrate the effect of that rule, Example 3's conclusion could then be reversed so as to provide that an enforceable promise gift does not successfully use up DSUE for estate tax computation purposes.

Standard BEA. As discussed, the Proposed Regulations provide an example clearly demonstrating the effect of a targeted gift on the use of DSUE. By contrast, the Proposed Regulations do not explicitly address a targeted gift's effect on the use of the standard BEA. Nevertheless, we think that the results under the Proposed Regulations are clear. Consider the following example:

A decedent dies when the BEA is $6.8 million. At a time when the BEA was $11.4 million, the decedent made an enforceable promise gift of $6.8 million. A few days later, the decedent made an outright gift of cash to the individual's child of $4.6 million.

In this example, for gift tax purposes, a targeted gift (i.e., a gift in the form of a promise that is enforceable under state law) uses up the standard BEA of $6.8 million, while a non-targeted gift (i.e., the outright cash gift) uses up the bonus BEA. For purposes of determining how much BEA is available at death, however, the Proposed Regulations disregard the targeted gift, so that the non-targeted gift of cash is deemed to be applied against only the standard BEA and fails to preserve any bonus BEA. The general anti-clawback rule, after all, provides that a decedent's taxable gifts must exceed the standard BEA in order to preserve bonus BEA for use at death. That is, the standard BEA must be exhausted before any bonus BEA can be preserved. No similar ordering rule appears in the Proposed Regulations. Thus, any targeted gift, including the $6.8 million enforceable promise gift in the foregoing example, is presumably disregarded in determining how much BEA a decedent used, even if, for gift tax purposes, the targeted gift was in fact applied against the standard BEA.

Example 2 of the Proposed Regulations confirms our interpretation that targeted gifts cannot use up standard BEA. In Example 2, a decedent simultaneously made both a $2 million enforceable promise gift and a $9 million cash gift (presumably, once again, without retaining an interest in the cash transferred), for total taxable gifts of $11 million. The example concludes that the decedent's estate computes estate tax based on a BEA of $9 million; that is, despite that the decedent, for gift tax purposes, made a total of $11 million of taxable gifts, the decedent's estate enjoys only the standard BEA of $6.8 million plus $2.2 million of bonus BEA, for a total of $9 million. If instead it were possible for a targeted gift, such as an enforceable promise gift, to use up standard BEA, then the example would instead conclude (or at least allow, depending on the sequence of the gifts) that the $2 million enforceable promise gift uses up $2 million of standard BEA, while the $9 million cash gift uses up the remaining $4.8 million of standard BEA, plus $4.2 million of bonus BEA. The total BEA available to the decedent's estate in that case would be $11 million, comprising $6.8 million of standard BEA and $4.2 million of BEA.

Although we do not disagree with the approach of the Proposed Regulations, reasonable minds may differ on whether targeted gifts should be allowed to absorb standard BEA. The Proposed Regulations themselves, by allowing the use of targeted gifts to absorb DSUE, provide some support for the view that targeted gifts should also be allowed to use up standard BEA. The DSUE and the standard BEA, after all, function similarly for purposes of determining how much applicable exclusion amount is available at death, in that both must be exhausted before any bonus BEA under the anti-clawback rule can be preserved. Treasury and the Service having decided that targeted gifts are acceptable in the DSUE context, consistency arguably favors a policy of also allowing targeted gifts up until the point that bonus BEA begins to be used.

Some may further argue that a targeted gift, standing alone, is not an abuse that should prevent the use of either DSUE or standard BEA. After all, if a decedent made an enforceable promise gift of $6.8 million but no other taxable gifts, and dies in a year when the BEA is $6.8 million, the anti-clawback rule has no effect. The BEA in that case would always be $6.8 million, with or without the anti-clawback rule, because the decedent's taxable gifts do not exceed the BEA available at death. Arguably, therefore, the potential for abuse does not begin until after the standard BEA (together with any DSUE) is exhausted. Only at that point should targeted gifts fail to lock in bonus BEA.

That said, the approach of the Proposed Regulations also has merit. As the preamble explains, targeted gifts are "essentially testamentary," in that they permit the donor to postpone until death the actual surrender of beneficial enjoyment. Given their essentially testamentary character, such gifts arguably should no more be allowed to facilitate the use of bonus BEA, by first absorbing DSUE and standard BEA, than to use bonus BEA directly.

Furthermore, if targeted gifts are permitted to use up either DSUE or standard BEA, then the amount of tax imposed at death will depend on the sequence of gifts, even if (as Example 3 provides) the gifts are made no more than "a few days" apart. Similarly situated taxpayers would then be treated differently merely because of the order in which they make targeted and non-targeted gifts. If a decedent does make both targeted and non-targeted gifts, but the targeted gifts, as the Proposed Regulations provide, are always disregarded for purposes of determining whether any standard BEA was used, then any "clawback" tax at death should, conceptually, be viewed as imposed on the targeted gifts, regardless of sequence. Thus, to ensure that targeted gifts are ultimately taxed without the benefit of enhanced exclusion, it is necessary for the final regulations to prohibit the use targeted gifts in order to absorb standard BEA.

We do not take a position on whether targeted gifts should be permissible techniques for using up either DSUE or standard BEA. That said, we do recommend that the final regulations address the disparity in treatment. Example 3 clearly permits targeted gifts to use up DSUE, yet the Proposed Regulations appear to take a different approach to the use of standard BEA. We do not see a strong basis for adopting a different policy in the latter case (standard BEA) than in the former (DSUE). If Treasury and the Service agree that the policies in both cases are aligned, then we think consideration should be given to broadening Example 3 to cover the standard BEA. If, on the contrary, there are policy reasons to treat DSUE and standard BEA differently, such that inconsistent results are preferable, then we think those results should be explicitly stated in an example and the rationale for the difference in result spelled out. Finally, if it is determined that the conclusion animating the result in Example 3 is incorrect, then we suggest that the final regulations retain the Example but reverse its conclusion, so that a targeted gift may not use up DSUE after all. In that case, as discussed above, Treasury and the Service may at the same time wish to propose amendments to the portability regulations that similarly provide that targeted gifts cannot be used to preserve DSUE before it is lost following remarriage and survival of a second spouse.

In all events, regardless of which approach the Treasury and the Service decide to adopt, we recommend, to avoid uncertainty, that the final regulations include an example expressly determining whether a targeted gift does or does not use up standard BEA. Such an example would either extend or stand in contrast to Example 3, which illustrates the effect a targeted gift on DSUE. If the final regulations maintain the apparent (if perhaps conceptually inconsistent) approach of the Proposed Regulations, then the two examples together would establish that, while a targeted gift may use up DSUE, it cannot use up any standard BEA. Alternatively, if the final regulations decide to treat DSUE and standard BEA in the same fashion, then the two examples would show either that (a) targeted gifts use up neither DSUE nor standard BEA or (b) targeted gifts are permitted techniques for using up both.

III. DEFINING THE CATEGORIES OF TARGETED GIFTS

We have two comments on how the proposed regulations define the categories of targeted gifts. The first is purely a drafting suggestion. Prop. Reg. §20.2010-1(c)(3)(i) begins by identifying two general categories of targeted gifts, namely, "transfers includible in the gross estate" and transfers "treated as includible in the gross estate for purposes of section 2001(b)." It then goes on to enumerate four types of targeted gifts, designated by clauses (A) through (D). Given the four enumerated types of targeted gifts, we think the two general categories set forth at the beginning of Prop. Reg. §20.2010-1(c)(3)(i) are both unnecessary and confusing. They are unnecessary because it appears that clauses (A) and (B) of Prop. Reg. §20.2010-1(c)(3)(i) exhaustively account, respectively, for "transfers includible in the gross estate" and transfers "treated as includible in the gross estate for purposes of section 2001(b)." They are confusing because clauses (C) and (D) describe transfers that are neither includible nor treated as includible in the gross estate. Rather than potentially mislead the reader into thinking that clauses (C) and (D) are instances of the two general categories of targeted gifts, the final regulations should instead acknowledge that they treat certain gifts as targeted gifts, regardless of whether they are included in the gross estate or treated as includible. Given the broad regulatory authority granted by Section 2001(g)(2), Treasury need not view gross estate inclusion as a necessary predicate for treating a transfer of property as a targeted gift.

Second, the Proposed Regulations do not explicitly address the impact of gifts that have the same economic effect as enforceable promise gifts. For example, suppose that a decedent made an outright cash gift of $9 million to the decedent's child, and that the child later lent the $9 million back to the decedent. Suppose, further, that the note remains unpaid on the decedent's death. This arrangement is economically similar to the enforceable promise gift described in Example 1 of the Proposed Regulations. Yet the arrangement, if it can survive scrutiny under substance-over-form principles, including the step transaction doctrine, would apparently allow the decedent to lock in bonus BEA, even though an equivalent enforceable promise gift would not. Rather than rely on the uncertain impact of substance-over-form principles, Treasury and the Service may wish to define a gift followed by a loan back to the donor as per se a targeted gift, if the loan occurs within certain period (such as 18 months of three years) following the gift.

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V. EXCEPTION TO THE DEFINITION OF TARGETED GIFTS

The purpose of the Proposed Regulations, as described in the preamble, is to prevent individuals from locking in bonus BEA with transfers that, while treated as gifts for gift tax purposes, do not actually "depriv[e] the donor of the use and enjoyment of the property." The preamble recognizes, however, that some transfers that might otherwise be treated as targeted gifts are not intended to permit the retention of the use and enjoyment of transferred property. So that the anti-abuse rule is not overbroad, the Proposed Regulations include a bright-line exception to the general definition of targeted gifts. Specifically, the Proposed Regulations provide that even if a transfer is includible in the gross estate, it is not considered a targeted gift if the taxable portion of the gift is 5% or less of the value of the transferred property.

Although we support a bright-line exception to the definition of targeted gifts, we recommend that Treasury and the Service reconsider the 5% test and craft a different exception that better distinguishes between transfers that do not actually deprive the donor of use and enjoyment of property — which should be treated as targeted gifts — and those where the donor actually surrenders beneficial use and enjoyment — which should not be considered targeted gifts. As discussed below, the 5% test does not provide an accurate approximation of whether a particular transfer was intended to take in appropriate advantage of the bonus BEA. Indeed, the 5% test seems to cut against the policy objectives described in the preamble: Whereas the rationale for denying the favorable anti-clawback rule to targeted gifts is to prevent the use of bonus BEA in cases where the donor effectively retains the beneficial enjoyment of the transferred property, the 5% test favors the retention of virtually all of the beneficial enjoyment, while rarely providing relief in cases where beneficial enjoyment is surrendered.

For example, suppose that a parent transfers $10 million to a trust for the exclusive benefit of a child, but retains the right to determine the timing and amount of distributions to the beneficiary. The initial transfer is treated for gift tax purposes as a completed $10 million gift. At the donor's death, however, the donor's retained power causes gross estate inclusion under Sections 2036(a)(2) and Section 2038(a). In this situation, the donor retains none of the beneficial enjoyment of the trust property. The rationale for denying the favorable anti-clawback rule, therefore, does not seem to apply. Nevertheless, the 5% exception does not help the taxpayer, as the entire transfer (far more than 5%) is treated a taxable gift.

We recognize that the preamble sometimes describes the rationale for the Proposed Regulations more broadly. For example, at one point, the preamble mentions" circumstances where the donor continues to have the title, possession, use, benefit, control, or enjoyment of the transferred property during life." The references to "title" and "control" could suggest that Treasury and the Service intend to deny the benefit of the anti-clawback rule where the decedent retains any power over transferred property that causes gross estate inclusion, even if the decedent did not retain any beneficial use or enjoyment for himself or herself. If that is the intent, then even a parent who retains no more than a power to control the timing of distributions to a child should not be able to lock in bonus BEA. If instead the intent is only to target gifts where the donor retains beneficial access, then the mere retention or possession of a taxable power should not by itself prevent a taxpayer from preserving bonus BEA. Rather, only the donor's effective retention of the right to the income, use, or enjoyment of the transferred property would be targeted.

If Treasury's and the Service's goal is only to prevent a donor from preserving bonus BEA while at the same time retaining beneficial access, then, in light of that goal, we note that, in some instances, the donor may retain a fixed interest in transferred property while fully surrendering the remainder. Consider, for example, the following three donors:

Donor A transfers $10 million outright to A's child. Donor A simultaneously transfers $5 million to a grantor retained annuity trust (GRAT) in which A retains a qualified annuity interest having a present value at the time of the gift of $4,750,000. The remainder of the GRAT is directed to be paid over to A's child.

Donor B makes a $15 million gift to a GRAT. Like A, individual B retains a qualified annuity interest having a present value at the time of the gift of $4,750,000. The remainder of the GRAT is directed to be paid over to B's child.

Donor C transfers $15 million to a limited liability company (LLC) having two classes of interests. Class 1 confers a right to guaranteed payments in fixed amounts, and has a fair market value for gift tax purposes of $4,750,000. Class 2 entitles the holder to the balance of the LLC's assets, after all guaranteed payments are made to the Class 1 interest holders. C makes a gift of the subordinate class 2 interests to C's child and retains the preferred class 1 guaranteed payment right.

In all three of the foregoing examples, the donor transfers a total of $15 million and retains a right to a fixed stream of payments having a present value of $4,750,000. Also in all three examples, the donor is treated, for gift tax purposes, as making taxable gifts of $10,250,000. Finally, in none of the three examples is the transfer subject to the special valuation rules of chapter 14 of the Code, nor does the donor retain an interest in the $10,250,000 remainder.

Despite the similar economics and identical gift tax treatment of the donors in the foregoing examples, the results under the Proposed Regulations are very different. Donor A successfully preserves $10,250,000 of BEA, as A's $10 million outright gift is not a targeted gift, while the gift of the GRAT remainder qualifies for the 5% exception. Likewise, donor C successfully preserves $10,250,000 of BEA, as C's gift of subordinate class 2 interests is not a targeted gift. Yet donor B, despite having surrendered a remainder interest valued for gift tax purposes at $10,250,000, fails to preserve bonus BEA if B dies holding the retained annuity interest.

The apparently arbitrary disparity in results arises because the 5% exception fails to exclude donor B's gift from the definition of targeted gifts. The 5% exception only applies where the donor has retained 95% of more of the beneficial interests. In other words, to avoid a targeted gift while retaining an interest, a donor (if the donor does not outlive the retained interest) needs to retain virtually all of the beneficial enjoyment of the transferred property. Yet the retention of beneficial enjoyment is the very abuse that the Proposed Regulations target. The retention of virtually all beneficial interests in transferred property is also disfavored in other contexts. If anything, it seems that where the requirements of the 5% rule are satisfied — such as in the case of a GRAT where the remainder has been virtually zeroed out — the benefit of the anti-clawback rule should be expressly denied, even if the donor outlives the retained interest and avoids gross estate inclusion.

In any event, so that policy of the Proposed Regulations can be better realized, we recommend that the Treasury and the Service abandon the 5% rule. Treasury and the Service should provide an exception to the definition of targeted gifts in cases where the donor retains no beneficial interest at all or retains no more than a qualified retained interest within the meaning of Section 2702(b). In such cases, the donor's taxable gift is not artificially inflated by the chapter 14 valuation rules. Further, the retained interest, because it is either a fixed annuity or unitrust amount, is not subject to manipulation; that is, a qualified retained interest does not permit the donor any access to the property interests that are given away. Indeed, the Proposed Regulations, by permitting the retention of guaranteed payment rights in entities, already correctly recognize that the retention of a right to payments in fixed amounts is not an abuse that should prevent the favorable anti-clawback rule from applying. Where such a right is retained, the donor has divested himself or herself of all transferred property other than the retained interest. Thus, the anti-clawback rule arguably should still apply.

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VI. POTENTIAL DISPARITIES CREATED BY THE 18-MONTH RULE

Pursuant to the Proposed Regulations, certain transfers which would have constituted targeted gifts but for the transfer, relinquishment or elimination of an interest, power, or property effectuated within 18 months of the date of the decedent's death, continue to be categorized as targeted gifts. Despite the Proposed Regulation's adoption of this 18-month rule, a statutory three-year rule would in certain cases still cause a loss of bonus BEA. Specifically, gifts includible in the gross estate pursuant to Section 2035 constitute targeted gifts. Section 2035, in turn, provides that if an individual transferred an interest in property or relinquished a power within three years prior to death and, but for the transfer or relinquishment the property would have been includible in the individual's gross estate under Section 2035, 2037, 2038, or 2042, the value of the transferred property is includible in the individual's gross estate. Because Section 2035 creates a three-year tail period, while the Proposed Regulations adopt an 18-month tail period, the Proposed Regulations would result in the disparate treatment of otherwise similarly situated individuals.

For example, consider an individual who makes a $9 million enforceable promise gift at a time when the basic exclusion amount is $11.4 million. Assume the individual subsequently satisfies the promised payment. Assume further that, two years after satisfying the promised payment, when the basic exclusion amount is $6.8 million, the individual dies. Under the Proposed Regulations, because the transfer in satisfaction of the promised payment occurs more than 18 months prior to death, the credit to be applied for purposes of calculating the individual's estate tax will be based on a $9 million basic exclusion amount.

A different outcome would result if the transfer were includible in the individual's gross estate pursuant to Section 2035. For example, consider an individual who transfers $9 million to a grantor retained income trust at a time when the BEA is $11.4 million. Assume that the individual subsequently relinquishes the income interest in the trust. Assume further that the individual dies two years after the relinquishment, when the basic exclusion amount is $6.8 million. Because the individual relinquished the income interest within three years of death, the entire value of the trust would be includible in the individual's gross estate pursuant to Section 2035. Therefore, under the Proposed Regulations, the credit to be applied for purposes of computing the individual's estate tax will be based on the $6.8 million basic exclusion amount.

Given that Section 2035 and the 18-month rule set forth in the Proposed Regulations both address the potential avoidance of the anti-abuse provisions of the Proposed Regulations through transfers shortly prior to death, we recommend that Treasury and the Service eliminate the disparities in outcomes in the case of changes that occur in the period that is more than 18 months before death but not more than three years before death. One way to eliminate those disparities is to exclude transfers that are includible in the gross estate under Section 2035(a) from the definition of targeted gifts found in paragraph (c)(3)(i) of the Proposed Regulations. With the three-year rule of Section 2035(a) disregarded, only actions taken within 18 months of death would fail to convert a targeted gift to a non-targeted gift that successfully locks in bonus BEA. Alternatively, if Treasury and the Service conclude that a uniform 18-month rule is too generous, the final regulations could replace the 18-month period in Prop. Reg. §20.2010-1(c)(3)(i)(D) with a period of three years. Given the three-year periods found for various purposes in Section 2035 and Section 2038(a), a three-year period arguably has more precedent than 18 months. The final regulations, under that approach, would impose a uniform three-year period before death when attempts to convert a targeted gift into a non-targeted gift would fail, regardless of whether Section 2035(a) applies.

E. Conclusions

Overlap exists as to the ACTEC and NYSBA submissions, including other matters which have not been mentioned. The approaches of the two named organizations differ as to the 18-month rule.

The suggestions of the two organizations will require considerable analysis by the IRS and the Treasury Department. Final regulations should be available within the next year and provide a sufficient period of time for analysis before the expiration of the bonus BEA period.

The ACTEC and NYSBA submissions point out the desirability, or perhaps the necessity, of the regulation process under the Administrative Procedure Act. Without review and comment, the end result would be less satisfactory regulations.

Another point is that with the passage of time, the work product of the IRS has, in our judgment, declined in its treatment of trust and estate matters. Some of the comments made by the two organizations should not have been needed. In making this statement, we recognize that the law has become more complex and this complexity has caused part of the problem.

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