28-Jan-21
The Net, Net Gift as a Hedging Strategy
Take-Away: With the current uncertainty with regard to the likelihood of new taxes, and the possible retroactive effect of new tax legislation, one way to mitigate the risks of a retroactive reduction in the federal gift tax exemption is with a net, net, lifetime gift agreement.
Background: President Biden has proposed a dramatic decrease in the amount of an individual’s federal gift tax exemption, which currently stands at $11.7 million per individual. If Congress acts to reduce the federal gift tax exemption to a lower amount, such as $5.0 million, $3.5 million, or even $1.0 million per person, and that reduction is made retroactive to earlier in this calendar year, that reduction in exemption could expose the donor to a federal gift tax when none was contemplated when the gift was made, since the donor had assumed that he or she possessed sufficient federal transfer tax exemption to fully shelter the lifetime gift from federal gift taxes. That possible exposure to a federal gift tax due to retroactivity might deter a donor from making a taxable gift while the gift tax exemption remains at the $11.7 million level.
Example: Ward has made several lifetime gifts. He has used up $6.0 million of his lifetime gift tax exemption amount, leaving him with $5.7 million in transfer tax exemption to use. Ward would like to use his remaining $5.7 bonus exemption that is available to him before that bonus exemption disappears in 2026. Ward is also aware of many of President Biden’s proposals to dramatically drop the federal gift tax exemption to $3.5 million per individual, making a delay in the gift until the end of 2025 problematic. While Ward is inclined to make the $5.7 million gift to his son Wally now following the use it or lose it principle, he is worried about an enacted reduced federal gift tax exemption made retroactive to the first of 2021. In short, Ward would make a gift of $5.7 million to Wally at this time, but Ward does not want to find himself later having to pay an additional federal gift tax of 40%, or an additional $2,280,000 out of Ward’s pocket.
Federal Gift Tax: A donor is generally liable for payment of the federal gift tax. [IRC 2502(c).]
Net Gift: However, if a gift is made subject to the condition that the donee must pay the federal gift tax liability, often referred to as a net gift, the donor’s gift will be determined by deducting the gift tax attributable to the transferred property from the value of the transferred property. This entails a circular computation, because the two variables are mutually dependent. There is, however, a simple formula provided by the IRS to calculate the amount of the gift under a net gift agreement. [Revenue Ruling 75-72.] Usually a net gift will not offer any tax savings, as the gift tax is the same whether the donor (i) makes a gift to the donee of the net amount and pays the gift tax, or (ii) the donor transfers the gross amount to the donee, and the donee is required to pay the tax.
Net, Net Gift: If the donor dies within three years of making the gift, a taxable gift also gives rise to a contingent federal estate tax liability. [IRC 2035(b).] That Code section adds back to the donor’s gross estate any gift tax paid. With a net, net gift the donee also agrees to pay any additional federal estate tax if the value of the gift tax is added back to the donor’s gross estate under IRC 2035(b). The IRS will claim that the calculation of a hypothetical estate tax liability, used to lower the value of the taxable gift to the donee is too speculative. This position was rejected, however, by a federal appeals court. Succession of McCord v. Commissioner, 461 3d 614 (5th Cir. 2006.) Accordingly, there is legal precedent for a net, net gift to a donee, which has the effect to further reduce the value of the gift to the donee.
Tax Implications of a Net, Net Gift: To summarize, the use of a net gift to a donee will reduce the amount of the taxable gift. Consequently, the amount of the federal gift tax imposed on that reduced-value gift will be less. In addition to the gift tax savings, there is potentially a second tax benefit to structure the gift as a net, net gift. If the donor dies within three years of making the gift, the amount of the gift tax includible in the donor’s taxable estate [IRC 2035(b)] is reduced, which in turn lowers the federal estate tax liability. In this situation, the donee’s assumption of the federal gift tax liability does not actually increase the donee’s tax exposure if the donee is the residuary beneficiary of the donor’s estate, and the donor’s Will directs that all estate taxes be paid from the residue of the donor’s estate. In this common situation, the federal estate tax liability under IRC 2035(b) would be borne by the donee, regardless of his or her assumption of the tax liability under the net, net gift agreement.
Planning Implications of a Net, Net Gift: As the prior example demonstrates, many donors may be sitting on the fence as to whether to make a large gift now, using what they believe to be their currently available bonus federal gift tax exemption while it still exists, but they may be reluctant to do so if there is a major legislative retroactive reduction in their gift tax exemption that they intend to shelter the lifetime gift from taxation. A net, net gift reduces the amount of the gift, and thus gift tax exposure, it further reduces the value of the gift if the donee assumes what is essentially a contingent federal estate tax liability. Finally, if there is a retroactive legislative change in the available exemption amount, the gifted amount becomes the source of payment of that unexpected gift tax, from the donee, and not the donor. Alternatively, if the federal gift tax exemption amount is legislatively reduced this year, but that change only has prospective effect, there will be no gift tax imposed on the gift, and the amount that the donee receives under the net, net gift agreement will not be reduced by a gift tax that is not owed. And if no gift tax is owed (and paid) the contingent liability for additional federal estate taxes under IRC 2035(b) will not exist either.
Net, Net Gift Agreement: An excellent example of a net, net gift agreement can be found in a 2008 Trusts and Estates article Arient & Frazier, “The Net, Net Gift.”
Conclusion: Standing alone, a net, net gift agreement is a way to save gift taxes, particularly for older clients who intend to make large lifetime gifts to the children but are reluctant to do so in light of the concerns about a retroactive reduction in their available federal gift tax exemption. Shifting the gift tax liability, if any, onto the donee’s shoulders might prompt some donors to proceed with their planned lifetime gifts this year.