In 2022, taxpayers have at their disposal a $12,060,000 Basic Exclusion Amount (BEA) for federal gift and estate tax purposes, as well as for the Generation-Skipping Transfer (GST) tax. The act known as the Tax Cuts and Jobs Act (TCJA) doubled the BEA from $5,000,000 to $10,000,000 for the years after December 31, 2017, and before January 1, 2026. With inflation adjustments, the BEA could increase from $12.06M in 2022 to $12.9M under some projections for 2023. Under current law, the BEA is scheduled to revert back to $5,000,000 along with inflation adjustments after December 31, 2025, unless new legislation changes that.

The additional “bonus” exclusion of $5,000,000 may provide individuals with more BEA than they will ever need. However, understanding how this bonus exclusion works in coordination with the BEA that may be available after 2025 is something that tax advisors and their clients should be aware of. This article discusses how this “use-it-or-lose-it” proposition really affects a taxpayer, along with several examples.

Background

For individuals passing away in 2022, the federal exemption for estate tax purposes is $12,060,000. In general, transfers to heirs above that exemption are taxed at 40%. In some circumstances, the exemption can be much larger for an individual, because for federal gift and estate tax purposes, an individual’s applicable exclusion amount is the sum of their BEA; in the case of a surviving spouse, their deceased spousal unused exclusion (DSUE) amount. [See IRC § 2010(c)(2).] A decedent spouse’s unused BEA can pass to the surviving spouse by making a portability election on a timely filed U.S. Estate Tax Return (Form 706). It is important to note that gifts made by a surviving spouse having the DSUE amount available are considered to apply their DSUE amount to the taxable gifts before their own BEA. [See Treas. Reg. § 25.2505-2(b).] This would mean that a surviving spouse would have to exhaust their DSUE before they could begin to use the additional $5,000,000 (adjusted for inflation) exemption available to them before 2026.

There was concern when this exemption doubled, especially for those who would have used their full increased BEA now and then passed away after 2025, when the BEA is scheduled to decrease. Would their taxable gifts be clawed back into their taxable estate with no corresponding credit equal to what was available to them at the time when they made the gift? Treasury Regulation § 20.2010-1(c), a.k.a. the “anti-clawback” regulations, assured individuals that the increased BEA that was available to them in 2018 through 2025 when they made a taxable gift, would also be available at death, when those adjusted taxable gifts are considered in the taxable estate.¹

Although many were relieved by the anti-clawback regulations, some may misunderstand the ordering and available use of their gift tax exemption in general. As discussed, an individual’s DSUE is used first and then their BEA is applied to taxable gifts. After the DSUE is utilized, the additional bonus exemption ($5,000,000 adjusted for inflation) should not be perceived as the next tier of exemption used, followed then by the original “base” exemption available pre-2017.

For simplicity, let’s assume there are no inflation adjustments to the BEA for a moment: If an individual made a taxable gift of $5,000,000 at any point in 2018 through 2025, then on January 1, 2026, there would be no BEA available for gifting. Come 2026, that individual would not be considered to have made a gift from the additional $5,000,000 “bonus” exclusion first. These donors were basically utilizing the BEA that was available to them at the time of the gift, and in 2026, $5,000,000 would be available to them. However, if they already used $5,000,000 of their BEA in prior years, then there is no BEA available to them. The following examples should help reinforce some common BEA usage (assume all gifts are post-1976).

Example 1

Fred never married and made taxable gifts of $5,490,000 as of 12/31/2017. In 2018, when the BEA increased to $11,180,000, he could make additional taxable gifts of $5,690,000 ($11.18M available; $5.49M used) sheltered from the gift tax. As the BEA increases each year for any inflation adjustments, Fred may transfer more wealth with no gift tax due.

Example 2

Fred and Wilma are married and were very concerned about estate tax law legislation at the end of 2021. They felt the BEA would decrease much sooner than 2026 and wanted to preserve the increased BEA available to them by funding a trust with Fred’s available BEA. So in 2021, Fred consulted with his attorney and created a spousal lifetime access trust (SLAT) that he funded with $11,700,000 for the benefit of Wilma. After the transfer to the SLAT in 2021, until the BEA increases for future inflation adjustments (i.e., the 2022 BEA is $12,060,000), Fred can no longer make a taxable gift without incurring gift tax.²

Example 3

Assume the same facts in Example 2, except that Fred funded the SLAT in 2021 with just $8,000,000, not $11,700,000. Let’s also assume the BEA is $8,000,000 with inflation adjustments in 2026, and he makes no further gifts from 2022 to 2025. Fred cannot make any taxable gifts in 2026 that are sheltered from the gift tax, because he has used all of his gift tax exemption. However, in later years, with additional inflation adjustments, he may then make additional taxable gifts without incurring gift tax.

Example 4

Fred passes away in 2022 and is survived by his wife, Wilma. Fred has not made any taxable gifts during his life and died when the BEA was $12,060,000. Fred’s executor makes an election for “portability” pursuant to Treasury Regulation § 20.2010-2. Wilma has made no taxable gifts during her lifetime. In 2022, she would have an applicable exclusion amount of $24,120,000, consisting of her basic exclusion amount of $12,060,000 and the DSUE that was “ported” to her. Let’s assume the BEA in 2026 is $8,000,000, and that Wilma passes away in 2026 having never made a taxable gift prior to her death. The credit to be applied for purposes of computing Wilma’s estate tax is based on her $20,060,000 applicable exclusion amount, consisting of her $8,000,000 BEA in 2026 plus the $12,060,000 DSUE amount.

For taxpayers that have enough asset sufficiency and can afford to use their full BEA without it affecting their lifestyle, the use-it-or-lose-it proposition is fairly simple. If you want to reduce federal estate taxes at death, then consider using all of the BEA that is available to you now. However, the proposition gets much more complicated for those taxpayers that have wealth approximately equal to the exemption today, not to mention state estate tax issues. They may need to strike a balance of examining asset sufficiency and estate tax planning, and then exploring the use of trusts with their attorney. In any event, anyone making wealth transfers prior to 2026 should understand where that exemption is coming from and what that exemption may look like in 2026.

Footnotes:

1. For a nice discussion of how the estate tax is calculated, please see the five statutory steps of the estate tax computation in part III, Federal Estate Tax Computation Generally, in the Background section of the preamble to the notice of proposed rulemaking under section 2010 (REG-106706-18) published in the Federal Register (83 FR 59343) on November 23, 2018.
2. This does not consider the fact that Fred could make a qualified terminable interest property (QTIP) election as late as 10/15/2022 in an effort to qualify the property in the trust for the gift tax marital deduction, leaving him even more BEA at his disposal after the transfer to the SLAT.
   

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel.

David M. Barral, CPA/PFS, CFP®, MST, is a Vice President and Wealth Advisor in Northern Trust’s New York City office. In this role, he serves as a financial planner to Northern Trust clients. David regularly works toward getting clients better organized; this frequently involves building out financial plans and projections for clients. David also works with clients to help articulate and implement these strategies with their outside advisors (e.g., attorneys, accountants, life insurance professionals). He can be reached at dmb21@ntrs.com.