Consider Making a Net Gift

Under the existing Tax Code, if a taxable gift is made, it is the donor who pays the federal gift tax, not the donee, or the recipient of the donor’s gift. However, a taxable gift can be structured where the recipient of the gift, not the donor, pays the federal gift tax liability. If the recipient pays the gift tax associated with the lifetime gift, not the donor, the result is a reduction in the actual gift tax rate. The recipient’s assumption of the donor’s gift tax liability is treated as partial consideration for the property that is transferred, and that reduces the amount of the gift for transfer tax purposes.

The IRS provides a circular method to compute the tax due on a net gift. First, the tentative gift tax that would be due on the gross gift is determined. Next, the net gift tax is computed using the IRS’s prescribed formula:

Trust tax = 1/(1+ Tax Rate) * Tentative Tax [Revenue Ruling 75-72]

Currently, the federal gift tax is at a 40% marginal rate. If the recipient of the gift agrees to pay the gift tax as a condition to receiving the gift, then the value of the gift is reduced by the amount of the gift tax paid by the recipient, which in turn reduces the amount of gift tax that is owed. Practically speaking, a net gift is treated as a partial gift, partial sale by the donor, since the donor receives something of value (or a partial sale) in the transaction in the form of being relieved of having to pay the federal gift tax liability.

Consider the following example where a net gift agreement is used. Donna makes a $1 million cash gift to her son Rex. Assume that Donna’s entire federal transfer tax applicable exemption was fully utilized by her in the past with her lifetime gifts to family trusts, so that Donna’s $1 million gift to Rex will cause a federal gift tax liability due of $400,000. The effective gift tax rate for Donna’s $1 million gift is 40%. Assume that Donna and Rex enter into a net gift agreement under which Rex agrees to pay any federal gift tax that is associated with his mother’s transfer of $1 million to him. With the net gift agreement, Donna’s gift to Rex of $1 million cash will cause Rex to pay a federal gift tax of $285,714. This gift tax paid by Rex reduces the value of Rex’s gift from $1 million to $714,286, which in turn results in a gift tax liability of $285,714 that is paid by Rex. [40% X $714,287 amount received by Rex = $285,714 gift tax paid by Rex.] By using a net gift agreement, the overall effective gift tax rate on the $1 million cash transfer to Rex drops from 40% ($400,000) to 28.57% ($285,714.)

However, if the $1 million net gift from Donna to Rex is appreciated marketable securities instead of cash, then Rex’s payment of his mother’s federal gift tax liability will result in capital gains tax liability for Donna, as she will be treated as having used appreciated assets to satisfy her tax-debt, i.e., Donna’s obligation to pay federal gift taxes as the donor was assumed by Rex, but she used appreciated assets to ‘purchase’ his assumption of her debt.

Net Gift Agreement Works Even Better With A Net, Net Gift Agreement

The concept of using a net gift agreement works even better with what is informally known as a net, net gift agreement. The way the federal estate tax is currently calculated causes the value of any lifetime gifts made by the decedent-donor within three years of his or her death to be added back into the decedent’s gross estate value for purposes of calculating the decedent’s federal estate tax liability. This ‘3-year-add-back’ rule causes additional federal estate taxes to be owed with the addition of the phantom gift tax values (only the value is added back to the decedent’s gross estate, not the underlying asset itself) which results only if the decedent-donor dies within three years of making his or her lifetime gift. Accordingly, a net gift agreement can thus be expanded to cover this contingent federal estate tax liability that the recipient of the gift also agrees to pay, hence, a net, net gift agreement. Such an agreement was formally approved by the U.S. Tax Court in Steinberg v. Commissioner, 145 Tax Court 184 (2015), which found that the recipients’ binding agreement to assume the contingent federal estate tax liability reduced the value of the gift to them.

If this contingent federal estate tax liability created by the net, net gift agreement is not included in the donor’s estate, i.e., the donor survived the 3-year ‘add-back period,’ then the donor of a net, net gift agreement would have additional tax savings at death within three years, with no downside.

A Net, Net Gift Agreement Works Best for Older Donors

The primary factor that is used to determine this contingent federal estate tax liability is the donor’s age. Less of a factor in determining this contingent estate tax liability is the applicable rate of interest (AFR) that is used to value the assumed additional estate tax liability. The older the donor, the greater the likelihood that transfer tax savings can be achieved because of the higher actuarial probability of the donor’s death within three years of his or her lifetime gift under the IRS’s actuarial tables that are used to calculate that contingent estate tax liability. Consequently, the value of the recipient’s contingent liability to pay this ‘additional’ federal estate tax results in a small lifetime gift, which leads to a smaller effective federal gift tax rate.

For example, Donna makes a lifetime gift to her son Rex of $10 million. Donna was aged 75 when her gift was made. A net, net gift agreement is used with Donna’s gift, under which Rex agrees to pay any gift tax and additionally any federal estate tax liability if Donna dies within three years of her gift. This net, net gift and estate tax agreement will save about $38,000 of gift taxes on Donna’s lifetime gift of $10 million to Rex. If Donna was age 95 at the time of her net, net gift agreement with Rex for $10 million, that agreement will save over $167,000 in federal gift taxes. If Donna is age 95, typically she has a greater actual, not just actuarial, likelihood of her death occurring within three years, which means there is a much greater likelihood that Donna’s death will occur within three years, i.e., a greater risk of increased federal estate taxes on Donna’s death. In sum, the best candidate for a net, net gift agreement is an older donor who is unusually healthy (i.e., likely to survive three years).

The Final Negative Consideration to Using a Net, Net Gift Agreement

The final negative consideration with respect to using a net, net gift agreement is the income tax basis of the asset that is the subject of the donor’s lifetime gift. If possible it is best to use high income tax basis assets as the subject of the net, net gift agreement. That is because the net, net gift agreement will be treated as a part sale, part gift transaction by its donor. It will be possible to trigger capital gains if the donor gifts low-tax basis assets, like a closely held business interest or depreciated real estate as the subject of the net, net gift agreement. Like any lifetime gift that is intended to remove appreciating assets from the donor’s taxable estate, a net, net gift agreement also means losing an income tax basis adjustment to those gifted assets on the donor’s death. If a higher tax basis asset is the subject of the lifetime gift, the loss of the income tax basis adjustment on the donor’s death, because it is a lifetime gift, is less significant.

As wealthy individuals exhaust their currently available applicable exemption amounts, or they find they have no exemption available if the sunset date for the large transfer tax exemptions occurs on January 1, 2026, more attention should be given to the use of a net, net gift agreement to reduce the effective transfer tax rate for lifetime gifts.