New York Retroactively Reinstates Its Estate Tax Clawback for Certain Taxable Gifts Made Within 3 Years of Death
On April 12, 2019, Governor Andrew Cuomo signed into law the New York Fiscal Year 2020 Budget (the “Budget Bill”). Included within the Budget Bill is an amendment to retroactively extend the three-year “clawback” provisions of Section 954(a)(3) of the New York Tax Law (the “NYTL”) to certain taxable gifts made by New York residents within three years of death up through the new expiration date of December 31, 2025 (the “three-year clawback”).
The three-year clawback had previously expired on January 1, 2019, and, by its terms, was to no longer apply to New Yorkers who previously made gifts and subsequently died after December 31, 2018. The Budget Bill, however, applies retroactively and now ensnares certain taxable gifts made within three years of death in the case of New York residents dying prior to January 1, 2026. This Stroock Special Bulletin discusses how New Yorkers may plan their estates in light of this new development.
New York’s Three-Year Clawback
The Governor’s Fiscal Year 2020 Executive Budget was released on January 15, 2019, and would have retroactively extended as of January 1, 2019, the three-year “clawback” provisions of NYTL 954(a)(3). That provision includes in a New York resident’s taxable estate the amount of any taxable gifts made by a person dying prior to January 1, 2019, reduced by certain carve-outs including for gifts made when a decedent was not a resident of New York, and gifts of real or tangible personal property having an actual situs outside New York state at the time the gift was made.
Under the Governor’s initial proposal, the January 1, 2019, expiration date for the three-year clawback was changed to January 1, 2026, and this provision would have applied retroactively as of January 1, 2019. Although the advocacy efforts of the New York State Bar Association and the New York State Society of Certified Public Accountants (with Stroock attorneys participating significantly in those efforts) were successful in removing the retroactive features of this statute for the period between January 1-15, 2019 (which preceded the release of the Governor’s executive budget on January 15, 2019), we are once again back to a regime where the three-year clawback must be considered in planning a New York resident’s estate.
The Federal and New York Estate Planning Landscape
As we have discussed in our prior Stroock Special Bulletins, Congress passed far-reaching changes to the Internal Revenue Code (the “2017 Tax Reform Act”) that provide significant estate planning opportunities. The federal estate, gift and generation skipping transfer (“GST”) tax exemptions doubled as of January 1, 2018, from $5,490,000 in 2017 to $11,180,000 per person (and to $22,360,000 for a married couple). These amounts are indexed for inflation and have risen to $11,400,000 per person ($22,800,000 for a married couple) for 2019. There is a “catch” to the federal legislation, as it “sunsets” the doubling of the federal estate, gift and GST tax exemptions on January 1, 2026, reverting to their pre-2018 exemption levels, as indexed for inflation.
For New Yorkers, the New York estate tax exemption has risen to $5,740,000 per person. In addition, there is no New York gift tax but taxable gifts made within three years of death are once again added to a New Yorker’s estate for estate tax purposes. The extreme market volatility, with wide swings in valuations of marketable securities and other asset classes, opens gifting opportunities.
These legislative developments and current market conditions create (1) a window of opportunity for gifting and other estate planning strategies to permanently remove assets from the future federal and New York estate tax, and (2) a need to review existing wills and other estate planning documents to ensure that they continue to carry out planning objectives.
A comparison of the federal estate, gift and GST tax provisions under the prior law and the 2017 Tax Reform Act is set forth below:
|Federal Transfer Tax|
as of December 31, 2017
|New Law – 2019
from January 1, 2019 through December 31, 2025
|New Law – 2026
as of January 1, 2026
|Estate, Gift and GST Tax Exemption Amounts||$5,490,000 per individual / $10,980,000 per married couple||$11,400,000 per individual / $22,800,000 per married couple for 2019, as indexed for inflation after 2019||$5,490,000 per individual / $10,980,000 per married couple, as indexed for inflation|
|Estate, Gift and GST Taxes Imposed||Yes||Yes||Yes|
Step-Up In Basis for Inherited Property at Death to Fair Market Value
|Estate, Gift and GST Tax Rates||40%||40%||40%|
|Gift Tax Annual Exclusion||$14,000 per donee ($28,000 if spouse elects to split gift)||$15,000 per donee ($30,000 if spouse elects to split gift)||$15,000 per donee ($30,000 if spouse elects to split gift), as indexed for inflation|
Expanded Gifting Opportunities to Transfer up to $11,400,000 per Individual ($22,800,000 per Married Couple) Gift-Tax Free
Although the doubling of the exemptions will not expire until the end of 2025, affluent individuals should consider securing use of the increased exemptions sooner rather than later.
Under the new tax law, individuals are now able to transfer $11,400,000 free of estate, gift and GST tax during their lives or at death. A married couple will be able to transfer $22,800,000 during their lives or at death. In addition, because of the portability provisions made permanent in 2013 by the American Taxpayer Relief Act, any unused federal estate tax (but not GST tax) exemption for the first spouse to die may be used by the surviving spouse for lifetime gifting or at death.
Individuals who previously exhausted their $5,490,000 gift tax or GST tax exemptions prior to 2018 now have the opportunity to gift another $5,910,000 (or $11,820,000 in the case of a married couple), and can even make such gifts to grandchildren or more remote descendants (or to trusts for their benefit) without incurring a GST tax.
The annual exclusion gifting amount has remained at the same levels as 2018 of $15,000 per donee (or $30,000 per donee if spouses elect to split gifts) for gifts made in 2019. This amount is subject to indexing in future years. Gifts in any amount for tuition or medical expenses, including health insurance, paid directly to the educational institution or medical provider continue to remain exempt from gift tax.
The temporary increase of the federal estate, gift and GST tax exemptions gives individuals vast opportunities to leverage their gifting. There was some concern that the sunset provisions of the 2017 Tax Reform Act could potentially pose a “clawback risk” if an individual were to gift away his or her entire gift tax exemption during that person’s lifetime and then die after December 31, 2025, at a time at which the unified estate and gift tax exemption was less than the amount that the individual had gifted away during that person’s lifetime. Congress recognized the need to address this potential issue by authorizing the U.S. Department of Treasury to issue guidance. On November 23, 2018, the IRS issued proposed regulations that provide for a revised calculation of taxable gifts made during life to essentially provide that there will not be a clawback for taxable gifts made prior to 2025 using the temporarily increased gift and GST tax exemptions.
The increase in the federal exemptions gives individuals expansive opportunities to leverage their gifting for multiple generations, including through the following techniques:
- Topping off prior planning by making gifts to existing and/or new family trusts including generation-skipping trusts and insurance trusts.
- Gifting residences or other assets to existing or new trusts that include spouses as discretionary beneficiaries (“SLATs”).
- Funding grantor retained annuity trusts (“GRATs”) and other types of trusts, to take advantage of the current market volatility and swings in valuation of marketable securities and other asset classes.
- Selling assets to intentionally defective grantor trusts (“IDGTs”) or where appropriate, making cash gifts to facilitate the prepayment of existing loans from senior family members.
- Making new intra-family loans or where appropriate, cash gifts to facilitate the prepayment of existing loans from senior family members.
- Allocating increased GST tax exemption to existing family trusts that were not exempt from GST tax.
These techniques are explained in more detail below.
Special Considerations for New York Residents —
Expanded Federal Exemptions Give New Yorkers Greater Opportunities to Plan Ahead to Permanently Reduce Their New York Taxable Estates and to Avoid the New York Estate Tax Cliff
As we reported in several previous Stroock Special Bulletins, New York state enacted legislation in 2014 reforming its estate and gift tax laws. One of the major changes of the 2014 New York tax law was the gradual increase of the New York state estate tax exclusion from $1,000,000 to the federal level, anchored, however, to the exemptions provided under then-existing federal tax law. As of January 1, 2019, the New York estate tax exclusion amount increased from $5,250,000 to $5,740,000. The New York estate tax exclusion amount is indexed for inflation with 2010 as the base year for this purpose. In addition, as previously noted, the law that added certain gifts made by a New York resident within three years of death to the estate for estate tax purposes has been extended through the end of 2025.
One of the reasons why New Yorkers should plan to maximize the use of both spouses’ New York exclusion amounts is that New York does not recognize portability of a deceased spouse’s unused exclusion amount to the surviving spouse as the federal law does. As a result, many New Yorkers will continue to incorporate credit shelter trusts or disclaimer trusts in their wills to maximize the benefits of both New York and federal law exclusion amounts.
A dramatic consequence to New Yorkers of the doubling of the federal estate tax exemption under the 2017 Tax Reform Act and the 2019 inflation adjustment is that there is now a $5,660,000 spread between the federal and New York state estate tax exemptions. Furthermore, the benefits of an increase in the New York exclusion amount are effectively denied to wealthier New Yorkers. There is a cliff built into the New York estate tax calculation, which quickly phases out the benefits of the exclusion if the decedent’s New York taxable estate (which previously included certain taxable gifts made within three years of death) is between 100% and 105% of the exclusion amount available on the date of death. The cliff completely wipes out the benefits of the exclusion if the decedent’s New York taxable estate exceeds 105% of the exclusion amount available on the date of death (the “New York estate tax cliff”). As a consequence, the increase in the New York estate tax exclusion amount only benefits individuals whose New York taxable estates fall below the New York exclusion amount in effect on the date of death. In addition, as mentioned above the New York estate tax exemption is not portable to spouses for use on the survivor’s New York estate tax return, in sharp contrast to the federal estate tax exemption. New York does not currently have a gift tax.
A comparison of the “spread” between the federal and New York state estate tax exemptions currently under the 2017 Tax Reform Act and as scheduled to sunset on January 1, 2026, is set forth below.
Spread Between Federal and New York State Estate Tax Exemptions
|Date of Death||Federal Exclusion||New York Exclusion||Spread|
|January 1, 2019, to December 31, 2025||$11,400,000*||$5,740,000*||$5,660,000*|
|January 1, 2026, and beyond||$5,740,000**||$5,740,000*||~$0**|
*Based on 2019 inflation-adjusted amounts. Indexed for inflation for each year after 2019.
** In 2026 the New York estate tax exemption is actually scheduled to be slightly higher than the federal estate tax exemption due to differences in their respective indexing methodologies.
As a result of the dramatic spread between the federal and New York estate tax exemptions, decedents whose estates are below the federal estate tax exemption amount may still owe significant New York estate tax if their estates exceed the New York estate tax exemption amount. For example, if an unmarried New York resident dies in 2019 with an estate of $10,000,000 (assuming no lifetime gifts were made), he or she will owe no federal estate tax, but will owe $1,067,600 in New York estate tax (based upon current rates).
New Yorkers whose estates are within the 100% – 105% “cliff” range, or even whose estates only slightly exceed the New York estate tax exemption amount, may consider gifting such amount as would bring his or her taxable estate below the New York estate tax exemption amount. As an example, an unmarried New Yorker who has assets with a current value of $6,200,000 and is in relatively good health may wish to consider gifting $460,000 at this time to his or her children or other intended beneficiaries. If such person dies after January 1, 2019, when the New York exclusion amount is $5,740,000 or greater, with a taxable estate of $5,740,000, his or her estate will owe no New York or federal estate tax. In contrast, if the gift is not made and the person dies in 2019 with a taxable estate of $6,200,000, the estate will owe $535,600 in New York estate tax (based upon current rates). To summarize, by making a gift of $460,000 today, this individual can save his or her beneficiaries over $500,000 in New York estate tax. This recommendation should not be affected by any subsequent changes to the federal estate, gift and GST tax laws.
A further benefit to New York residents making lifetime gifts within the parameters of the expanded federal exemption is the ability to permanently move assets out of the New York taxable estate without incurring any state-level gift tax (provided that they survive the gift by three years). Because New York has no gift tax, New Yorkers have the ability to permanently insulate gifted property from New York estate tax and may have the added benefit of reducing their New York taxable estate below the applicable exclusion amount on the date of their death, provided that they survive the gift by three years. Alternatively, a New Yorker could purchase real estate located outside of New York, or relocate tangible personal property to a state other than New York, and thereby avoid the New York estate tax on those assets. For some, this also can avoid the confiscatory impact of the New York estate tax cliff. For example, a gift of $11,400,000 by a New York resident can potentially save from $1,290,800 to $1,824,000 (depending on the total size of the taxable estate) of New York state estate tax. The New York estate tax savings could potentially be doubled if both spouses were to fully use their federal exemptions by making lifetime gifts.
The potential tax savings of such a gifting program should also be considered in tandem with the temporary expansion of the federal estate, gift and GST tax exemptions before the federal exemptions revert to pre-2018 exemption levels on January 1, 2026. If one were also to factor in the sunset of the doubling of the federal estate, gift and GST tax exemptions on January 1, 2026, back to pre-2018 exemption levels, the combined federal and New York state estate tax savings from such gifts at this time would be increased by another approximately $2,260,000 for an individual and $4,520,000 for a married couple, for a total of more than $3,500,000 for an individual and more than $7,000,000 for a married couple, as compared to persons who do not embark on a gifting program and allow their expanded federal exemptions to revert to pre-2018 exemption levels on January 1, 2026.
Potential Federal and New York Tax Savings In Gifting Up To Federal Exemption
|Amount of Gift Before 2026||Minimum New York State Estate Tax Savings||Federal Estate Tax Savings For Death After 2026||Combined Federal and New York Estate Tax Savings For Death After 2026|
|$11,400,000, for an individual||Approximately $1,290,000||Approximately $2,260,000||Approximately $3,550,000|
|$22,800,000, for a married couple||Approximately $2,580,000||Approximately $4,520,000||Approximately $7,100,000|
As always, the potential estate, gift and GST tax savings should be weighed against the potential loss of the step-up of income tax basis for assets included in a decedent’s taxable estate.
Popular Wealth-Transfer Techniques to Leverage Expanded Federal Gift and GST Tax Exemptions Remain Viable
In light of the significant increase to the federal estate, gift and GST tax exemptions and the extreme market volatility, individuals who wish to reduce or eliminate future estate taxes may consider maximizing their use of the increased gift tax exemption before the exemptions revert to pre-2018 levels on January 1, 2026. Strategies that are attractive include dynasty (generation-skipping) trusts, spousal lifetime access trusts (“SLATs”), grantor retained annuity trusts (“GRATs”), intra-family loans and sales to intentionally defective grantor trusts (“IDGTs”). Each transaction must be handled with proper professional guidance to ensure that the transaction is carried out properly. Brief explanations of these estate planning techniques are set forth below.
Dynasty (Generation-Skipping) Trusts
Through coordinated use of their federal gift and GST tax exemptions, individuals can create trusts with an aggregate value of up to $11,400,000 ($22,800,000 per married couple), which may benefit several generations of descendants while insulating the assets from gift, estate and GST taxes. These are sometimes referred to as “dynasty trusts.”
The creator of the trust would allocate GST tax exemption to the trust and fund the trust with assets likely to appreciate in value. Those assets would then be removed from the estate of the creator of the trust, and would not be included in the estate of his or her children and grandchildren, allowing the trust to grow free of transfer taxes for multiple generations. In addition to mitigating the impact of transfer taxes, a dynasty trust can help shield a family’s assets from creditors, claims in the event of divorce and poor decisions of future beneficiaries.
Spousal Lifetime Access Trusts (“SLATs”)
Dynasty trusts may be structured to give the grantor’s spouse access to the trust as a discretionary beneficiary of trust income and principal. Such trusts with spousal access rights are sometimes referred to as “spousal lifetime access trusts,” or “SLATs.” The trust also can name children and grandchildren as beneficiaries.
As with the dynasty trust, GST tax exemption can be allocated to the trust and future appreciation on the SLAT assets are shielded from transfer taxes. Such trusts can provide additional comfort that transferred wealth would still be available for a married couple if needed down the road through distributions to the spouse. The assets essentially can serve as a “rainy day fund” while allowing one to take maximum advantage of the new tax laws.
Grantor Retained Annuity Trusts (“GRATs”)
Grantor Retained Annuity Trusts (“GRATs”) are a popular technique used to transfer assets to family members without the imposition of any gift tax and with the added benefit of removing the assets transferred into the GRAT from the transferor’s estate (assuming the grantor survives the initial term which can be as short as two years). GRATs take on added significance in a time of extreme market volatility where there is opportunity to take advantage of funding a GRAT when there is a downswing in values.
In a GRAT, you transfer assets to a trust, while retaining the right to receive a fixed annuity for a specified term. The retained annuity is paid with any cash on hand, or if there is no cash, with in-kind distributions of assets held in the trust. At the end of the term, the remaining trust assets pass to the ultimate beneficiaries of the GRAT (for example, your children and their issue or a trust for their benefit), free of any estate or gift tax.
The GRAT can be funded with any type of property, such as an interest in a closely held business or venture, hedge fund, private equity fund or even marketable securities. The most important consideration is whether the selected assets are likely to appreciate during the GRAT term at a rate that exceeds the IRS hurdle rate (an interest rate published by the IRS every month). The value of the grantor’s retained annuity is calculated based on the IRS hurdle rate – the lower the IRS hurdle rate, the lower the annuity that is required to zero out the GRAT. The hurdle rate is 3.0% for transfers made in April 2019. If the trust’s assets appreciate at a rate greater than the interest rate, the excess appreciation will pass to the ultimate beneficiaries of the GRAT free of any gift tax. Thus, any asset that you think will grow more than 3.0% a year may be a good candidate for funding a GRAT.
Other factors to take into account in selecting the assets to be gifted are whether the assets currently have a low valuation or represent a minority interest (which may qualify the assets for valuation discounts for lack of control and lack of marketability under current law).
Generally, the GRAT is structured so as to produce little or no taxable gift. This is known as a “zeroed out” GRAT. Under this plan, the annuity is set so that its present value is roughly equal to the fair market value of the property transferred to the GRAT, after taking into account any valuation discounts. There is virtually no gift tax cost associated with creating a zeroed out GRAT.
Other benefits of a GRAT bear mentioning. The transfer to a GRAT is virtually risk-free from a valuation perspective. If an asset for which there is no readily ascertainable market value is transferred to a GRAT and the IRS later challenges the value that you report for gift tax purposes, the GRAT annuity automatically increases in order to produce a near zero gift. Accordingly, there is essentially no gift tax exposure. It should be noted, however, that GRATs generally do not provide the same opportunity for leverage for GST tax purposes that other estate planning techniques can provide in connection with transfers to or for the benefit of grandchildren or more remote descendants.
There may be no better time than the present to consider GRATs: The IRS hurdle rate remains low; the market is volatile; and valuation discounts are available.
Income Tax Considerations
GRATs, SLATs and certain dynasty trusts mentioned above also enjoy an income tax advantage.
A GRAT or a SLAT is a “grantor trust,” and a dynasty trust can be structured as a grantor trust, meaning that you must pick up all items of income, credit and deduction attributable to the trust property on your personal income tax return. Being saddled with the income tax liability may seem like a burden, but it is actually a great estate planning advantage, in that it allows the trust property to grow income tax free for the beneficiaries, while reducing your estate gift tax free.
Another important feature of a grantor trust is that the trust can permit the grantor to swap personal assets with assets in the trust. This can be a very valuable technique for income tax basis planning.
Another technique that works very well in a low interest rate environment is an intra-family loan. Each month the IRS publishes interest rate tables that establish the lowest rate that, if properly documented, can be safely used for loans between family members without producing a taxable gift.
Currently, these interest rates are near historic lows. For April 2019, the short-term rate for loans of up to three years is 2.52%; the mid-term rate for loans of more than three years and up to nine years is 2.55%; and the long-term rate for loans exceeding nine years is 2.89%. Funds that are lent to children, or a trust for the benefit of children, will grow in the senior family member’s estate at this extraordinarily low interest rate, essentially creating a partial estate freeze plan. Those funds, in turn, can be put to use by the junior family member to purchase a residence or may be invested in a manner that hopefully will beat the hurdle interest rate.
Making a loan to a trust for your children may be even more advantageous than making a loan outright if the trust is intentionally structured as a grantor trust for income tax purposes. Ordinarily, the interest payments on the note must be included in your taxable income, but if the payments are made by a grantor trust, they will have no income tax ramifications to you.
Alternatively, depending upon one’s circumstances, it may be more advantageous for senior family members to put some of their expanded federal gift and GST tax exemptions to work by making cash gifts to facilitate the prepayment of existing loans to family members and to trusts established for the benefit of family members.
Sales to Intentionally Defective Grantor Trusts
A sale to an intentionally defective grantor trust (“IDGT”) can be an extremely effective planning strategy that takes advantage of the current market conditions. In the case of a sale of a minority interest in an entity or a fractional interest in real property, valuation discounts can also be leveraged. You would create an IDGT for the benefit of your children, grandchildren and more remote descendants. If there is an existing IDGT, all the better.
An IDGT provides two independent planning opportunities. First, you will pay the income tax on the income generated by the trust, including capital gains tax, thereby allowing the trust to grow for your children and their issue unencumbered by the income tax, while reducing your estate. In addition, you may engage in transactions with an IDGT without any income tax consequences.
For example, you can sell low basis property to an IDGT without recognizing a gain. An ideal way to lock into valuation discounts would be to sell a minority interest in a closely held business or venture to an IDGT. That minority interest can be sold at a price taking into account discounts for lack of control and lack of marketability.
Under this plan, you would sell property to the trust and take back a note with fixed payments of interest and principal. Any property can be sold to an IDGT, but ideally the property would have a low current valuation, good prospects for appreciation and features that enable it to qualify for valuation discounts. If the principal on the note equals the fair market value of the property sold, no taxable gift results. In addition, if the assets appreciate in value above the interest rate on the promissory note, the excess growth in value may be used to retire the principal of the debt, leaving valuable property for your children free of transfer tax. In addition, by making a small gift to the IDGT and allocating GST tax exemption to the IDGT, the appreciation also can continue to grow for multiple generations free of transfer tax.
Individuals who have previously exhausted their exemptions through prior gifting may want to leverage their gifting and the valuation discounts even further through new sales to grantor trusts or, where appropriate, by making cash gifts to facilitate the prepayment of existing installment obligations to senior family members from prior sales, before the expanded federal exemptions revert to their pre-2018 levels on January 1, 2026.
As mentioned above, the interest rates that can be used for this purpose are currently extraordinarily low. Unlike with GRATs, however, such plans may have valuation risks that need to be considered, particularly if the property sold is an interest in a closely held business or venture. Under certain circumstances, the temporarily expanded federal exemptions can be used as a cushion against valuation risks and against a valuation adjustment on audit. A senior family member can sell an interest in a closely held business or another hard to value asset to an IDGT, leaving a cushion for a valuation adjustment on audit. At the expiration of the three-year statute of limitations, the donor will have certainty as to his or her remaining exemption and can utilize the remaining exemption to “top off” additional gifting before January 1, 2026, when the federal exemptions revert back to pre-2018 levels. Therefore individuals should embark on such a plan as soon as possible.
Although sales to intentionally defective grantor trusts have been used widely for decades, in some recent audits, the IRS has attacked the technique on two fronts: first, by taking the position that the note given to the grantor by the trust in exchange for the purchased property should be ignored, resulting in a gift of the full value of the property transferred, and second, by attempting to treat the note as “equity” in the trust rather than “debt,” resulting in the inclusion of the asset transferred to the trust in the grantor’s gross estate for estate tax purposes. Although most practitioners believe that the IRS’s positions conflict with the Internal Revenue Code, Treasury Regulations and prior case law, these audit challenges may be an indication that the IRS intends to attack such sales more vigorously.
The IRS recently brought a high-profile challenge to a sale to a grantor trust in two companion Tax Court cases. In these cases, which involved a husband and a wife, the grantor sold assets to the trust in exchange for a promissory note that contained a “defined value formula.” The formula provided that if the value of the assets were later determined by the IRS or a court to be different than the appraised value, the number of shares purchased would be adjusted to avoid the imposition of a partial gift tax. Both cases settled in March 2016, without the Tax Court having ruled on the efficacy of the defined value formula. There is a prior court case that supports the validity of this technique, but the IRS has made clear that it will continue to challenge defined value transactions.
Taking Advantage of Extraordinary Planning Opportunities Now
Under the 2017 Tax Reform Act, the federal gift, estate and GST tax exemptions increased to $11,400,000 on January 1, 2019 ($22,800,000 for a married couple), allowing individuals extraordinary multi-generational estate planning opportunities to use these exemptions through lifetime gifting before the exemptions revert to their pre-2018 levels on January 1, 2026. In addition, the current New York law and market conditions are generally favorable to many planning techniques. Selecting the optimal wealth transfer technique and the right assets to gift (taking into account the assets’ basis) are of paramount importance.
Stroock’s Private Client Services Practice Group continues to monitor all developments out of Washington and will provide updates and guidance, including with respect to the U.S. Department of the Treasury and the Internal Revenue Service’s issuance of guidance to address open points in the new legislation.
For More Information
 Public Law 115-97, also known as the “Tax Cuts and Jobs Act.”