Trust and Estate Counsel

Tennessee Estate Planning Law

Insight and commentary on estate planning issues impacting affluent residents of Tennessee

The Great 2012 Gifting Opportunity - Part 5: Tennessee Gift Tax Clawback

This is the fifth article of a series designed to provide guidance for those individuals who are considering making a large gift in 2012 to take advantage of the $5.12 million federal gift tax exemption that will expire at the end of the year. For prior articles, see:

          Part 1: Use It or Lose It,

          Part 2: Can You Afford to Make a Large Gift?,

          Part 3: When Should You Make the Gift?, and

          Part 4: Will a Large Gift Demotivate Your Children?

Two weeks ago, the Tennessee legislature decided to repeal Tennessee gift taxes, effective as January 1, 2012. They also agreed to phase out inheritance taxes over a four-year period. The combination of the total repeal of the gift tax and the phased out repeal of the inheritance tax creates an unintended consequence. Assume that a client makes a gift of $5,120,000 in 2012 and then dies in 2013 owning no assets. There would be no federal or Tennessee gift tax associated with the gift in 2012. There has been some uncertainty regarding the federal estate tax consequences. The majority of commentators assume that there will be no federal estate tax. Nevertheless, some believe that the IRS will try to assess estate taxes even though the estate has no assets. This danger of paying estate taxes based on a tax-free gift is referred to as “clawback”.

Tennessee definitely has a clawback problem. Unlike the federal statute, the Tennessee statute is very clear. When you die, you must add back to your estate gifts made within three years prior to death (other than gifts covered by the $13,000 annual exclusion). This means that the estate will have a phantom asset of $5,120,000 for Tennessee inheritance tax purposes. After subtracting the Tennessee inheritance tax exemption of $1,250,000 in 2013, the estate will owe Tennessee inheritance taxes on $3,870,000. The tax on this amount equals $356,000. Even though there was no tax on the gift when made and the person died with no assets, his or her estate will owe $356,000 of Tennessee inheritance tax.  

You are probably wondering who will pay the tax. There is legal concept called transferee liability that would make the donee of the gift liable for the tax if the estate cannot afford to pay it.

If the client is not married or does not intend to use the marital deduction, making the gift in 2012 will not increase their overall Tennessee taxes as compared to not having made the gift. However, if the client is married and plans to use the Tennessee inheritance tax marital deduction, the 2012 gift can result in a tax when there would not have otherwise been a tax if no gift had been made. If no gift had been made, the client could set aside $1,250,000 in a credit shelter trust, or give it directly to children. The remainder of the estate would pass to the spouse or to a marital trust. Under this no gift scenario, no Tennessee tax would be owed at the death of the first spouse. If the surviving spouse lives at least until 2016, no Tennessee tax would ever be owed. A method for couples to solve this potential problem will be discussed in the next article.

As a practical matter, the danger of owing a tax when you own nothing or plan to give everything to your spouse will dissipate if you survive at least until 2015. In 2015, the inheritance tax exemption will equal $5,000,000, which will almost totally cover a gift of $5.12 million in 2012. In 2016, the problem totally disappears because the Tennessee inheritance tax will be gone.  

The risk of incurring a Tennessee tax should be weighed against the potential reduction of federal transfer taxes by making a gift in 2012. As a general rule, we believe the potential federal tax benefits far outweigh the risk that you will incur some incremental Tennessee inheritance taxes.

In summary, if you make a large gift in 2012 and then die within three years, your estate may owe Tennessee inheritance taxes based on the gift. This danger should not stop you from making a gift that otherwise makes sense.