Take-Away: If a client has fully utilized their applicable federal gift and estate tax exemption amount on lifetime gifts, they should consider the use of a net gift agreement if they want to continue to move appreciating assets out of their taxable estate through lifetime gifts. Better yet, they should consider using a net-net gift agreement. The net gift strategy is also often used to give away a specific asset at a reduced gift tax cost when there is not enough liquidity available to the donor to pay the gift tax liability due on the gift. When a net gift strategy is used the donor’s estate tax allocation clause in their estate planning documents needs to be reviewed and possibly altered to reflect the estate tax implications of the net gift.

Background:  With a net gift strategy the donee contractually agrees to assume and pay the donor’s legal obligation to pay the gift tax imposed on the transfer to the donee. The shift of this gift tax obligation from the donor to the donee reduces the net amount of wealth that is transferred as the gift; accordingly,  it reduces the gift tax that is ultimately paid.

  • Circular Calculation: This reduction in the gift tax increases the net amount that is being transferred. Back and forth the circular calculation goes until the difference is less than $1.00 and the amount of the gift tax is finally determined. This ‘circular’ calculation of the net gift is outlined in Revenue Ruling 75-72, 1975-1 CB 310.
  • Three Year Look-Back Rule: A net gift can cause a problem for the donor who dies within three years of the net gift. That is because IRC 2035(b) includes in the donor’s gross estate for estate tax calculations the value of the gift tax that is paid, even when the donee  pays the gift tax. Estate of Sachs, 856 F.2d 1158 (CA-8, 1988.) IRC 2035(b) includes in the decedent’s gross estate the gift taxes that are paid on gifts made within three years of the donor’s date of death; this section was added to the Tax Code in 1976 to eliminate any incentive for donors to make deathbed gifts to remove an amount equal to the gift tax from the donor-decedent’s transfer tax base.
  • Phantom Asset: Consider a situation where the donor enters into a net gift arrangement with the donee, but the donor dies within three years of the gift. The value of the gift tax paid by the donee is added back into the donor’s taxable estate (it is treated as a phantom asset) which causes more federal estate tax to be owed by the donor’s estate. If the beneficiaries of the donor’s estate are different than the donee who received the lifetime net gift, there exists a disproportionate estate tax burden placed on the estate beneficiaries who indirectly end up paying the federal estate tax by receiving a smaller inheritance from a smaller net estate after all the federal estate taxes are paid. If the lifetime donee and the estate beneficiary are the same, or the donee is one of many estate beneficiaries, the additional estate tax caused by the ‘add-back’ of the gift tax paid, can be directly allocated by the decedent and taken from the donee’s share of the decedent’s estate by a directive in the donor’s estate tax allocation clause. But if the donee of the net gift is not a beneficiary of the donor-decedent’s estate, one or more estate beneficiaries will get stuck pay an additional federal estate tax on a phantom asset , i.e. the gift tax amount paid that was added to the decedent’s taxable gross estate.

Practical Example: Father enters into a lifetime net gift with a child he has from a prior marriage. Father dies within three years of that net gift. By his trust father leaves his entire estate to his second wife. Normally leaving the entire decedent’s estate to a surviving spouse will qualify for the federal estate tax marital deduction. IRC 2056.  But the phantom asset, i.e. the net gift tax paid by the child on father’s lifetime net gift, will not qualify for the marital deduction because the phantom asset does not pass outright to the surviving spouse. If father had consumed all of his applicable exclusion amount in other lifetime gifts, so that no federal estate tax credit is available to shelter his estate tax liability on the father’s death, then the assets otherwise destined to be distributed to the father’s surviving spouse will have to be liquidated and used to pay the federal estate tax imposed on that phantom asset. That, in turn, reduces the amount of assets that pass to his surviving spouse, which results in a smaller marital deduction amount claimed. In short, a federal estate tax will have to be paid when all of the decedent’s assets passed to his surviving spouse. If the second spouse and the child from the earlier marriage received the net gift do not get along with one another, you can imagine the problems the add-back of the gift tax paid will cause in the deceased father’s estate administration.

Real Life Example:  The above example occurred in a  Tax Court decision, Estate of Sommers, Tax Court Memo, 2013-8. There the donor placed valuable artwork {e.g. Calders, Miros, and Dali artwork] in an LLC and gifted LLC units to his nieces using a net gift agreement. He also claimed valuation discounts for the LLC units that were the subject of the net gifts.  The nieces paid the gift tax due, per their agreement with their uncle. Their uncle died within three years of the gifts of the LLC units. Making matters worse, the discounted value of the gifts of the LLC units was successfully challenged by the IRS,  and an additional gift tax was imposed on the gifted LLC units. The nieces dutifully paid the additional gift tax due resulting from the gift tax deficiency determination. But then the whole issue of the net gift-phantom asset reared its ugly head when the widow of the uncle, who received the balance of his estate, filed a lawsuit and argued that the nieces should pay the additional federal estate tax due as a result of the add-back of the value of the gift tax paid (by the nieces) which increased their uncle’s gross taxable estate. The widow argued that the state’s estate tax allocation statute applied (the uncle’s tax allocation clause in his trust was silent on this issue) claiming that  it shifted the federal estate tax burden onto the nieces. The Tax Court held that the state (New Jersey) tax apportionment statute did not apportion to the nieces the federal estate tax imposed on the gift taxes that they had paid that were included in the uncle’s taxable estate under IRC 2035(b). Rather, those federal estate taxes would be apportioned against the marital share and consequently reduce the allowable federal estate tax marital deduction. In reaching this conclusion the Tax Court recognized that its decision placed a disproportionate , i.e. ‘unfair, ’ estate tax burden on the estate’s sole beneficiary, the widow of the decedent, and it acknowledged that some states have interpreted their estate tax allocation statutes differently imposing the additional estate tax burden on the lifetime donees who received the gift rather than on the estate beneficiaries, but the Tax Court chose not to do so in this case, leaving the widow stuck paying the federal estate tax on the net gift-phantom asset.

Tax Allocation Clause:  If a donor decides for whatever reason to engage in a lifetime net gift agreement  with the donee, the implications of the donor’s death within three years of that gift and its impact on the donor’s estate tax liability should be addressed in the estate tax allocation clause contained in the donor’s estate planning documents, and not rely on a state estate tax allocation statute.

Net-Net Gifts: Even better is if the donor and the donees to enter into a net-net gift agreement, where the donees agree to pay not only the federal gift tax imposed on the lifetime gift, but they also agree, in the same document, to pay any federal estate tax imposed on the donor’s estate if the donor dies within three years of the net gift and the gift tax paid is added to the donor’s gross estate as a phantom asset.  The Tax Court has held that the amount of the donor’s taxable gift in such cases is reduced not only by  the donee’s promise to pay the federal gift taxes but also the actuarial value of the donee’s promise to pay any federal estate taxes under IRC 2035(b) if the donor’s death occurs in three years. The value of the donee’s promise to pay the federal estate taxes under IRC 2035(b) is calculated by taking into account the actuarial likelihood that the donor will die in each of the three years that follow the date of the net gift. In Estate of Steinberg, 141 Tax Court 258 (2013 and Steinberg. 145 Tax Court 184 (2015) the IRS unsuccessfully argued that since the donor did survive the three years after the gift that the value of the net gift should not have been reduced to reflect a federal estate tax liability that would never have to be paid by the donees. The Tax Court found that the risk of the grantor dying within three years of the gift that would trigger an increase in federal estate taxes due was a legitimate liability assumed by the donees at the time of the gift and consequently that additional liability, albeit contingent, appropriately reduced the value of the lifetime gift that the donees received.

Conclusion:  While not too many taxpayers are prepared to enter into tax gift transactions to reduce the size of their taxable estates, for those who have fully utilized their applicable exemption amounts, the net gift strategy is a useful tool to both reduce the size of the gift, and the corresponding gift tax liability that is owed. It can also be an effective device if the donor does not possess sufficient liquidity to pay the gift tax, but the donees do have enough liquidity to pay the tax. Using a net-net gift agreement can further reduce the size of the gift, and thus the amount of the gift tax ultimately owed. If clients find themselves without a gift tax exemption available, or without the necessary liquidity to pay the federal gift tax that will be owed, they should consider the possible use of a net-net gift agreement. If only a net gift is used, then the donor should adjust the tax allocation clause in their estate planning instruments to address the possibility of the gift tax being added back to the donor’s estate as a phantom asset on which estate taxes must be paid.