Exhausted Your Gift Tax Exemption? Consider a Net Gift

Net gifts are gifts of money, property or assets for which the giver agrees to pay the gift tax — thus reducing the value of the gift for tax purposes. It can be appealing if you've exhausted your lifetime gift tax exemption. Another option is the "net, net gift," which can enable you to finance your gift recipient's tax liability so that he or she receives the full amount. Let's take a look.

Demonstrating the Benefits

The easiest way to demonstrate the benefits of a net gift is through an example. Suppose you wish to make a $1 million gift to your adult son. For purposes of this example, also assume that you've already exhausted your federal gift and estate tax exemption amount, so the gift is fully taxable. At the current 40% marginal rate, the tax on your $1 million gift would be $400,000. However, if your son agrees to pay the gift tax as a condition of receiving the gift, then the value of the gift would be reduced by the amount of tax, which in turn would reduce the amount of gift tax owed.

Gift with a yellow ribbon

Rather than get caught up in an endless loop of calculating the tax, reducing the gift's value, recalculating the tax, and so on, there's a simple formula for determining your son's tax liability: Gift tax = tentative tax/(1 + tax rate).

In our example, the tentative tax is $400,000 (the tax that would have been owed on an outright gift), so the gift tax on the net gift would be $400,000/1.4 = $285,714. You can confirm that the math works out by assuming that you give your son $1 million and that he agrees to pay $285,714 in gift taxes. That tax liability reduces the gift to $1 million - $285,714 = $714,287, resulting in a tax liability of .40 x $714,287 = $285,714.

By using a net gift technique, you reduce the effective tax rate on the $1 million transfer from 40% to only 28.57%. Note that if the gift is in the form of appreciated assets rather than cash, the recipient's payment of the tax liability can result in capital gains taxes for the donor.

A Step Further

It may be possible to reduce the effective gift tax rate even further by using a net, net gift. Under this technique, in addition to assuming liability for gift taxes, the recipient also agrees to pay any estate tax liability that might arise by virtue of the so-called "three-year rule."

Gifts made within three years of death are pulled back into the donor's estate and subject to estate taxes. The U.S. Tax Court has given its blessing to the net, net gift technique. It has ruled in favor of allowing the value of a gift to be reduced by the actuarial value of the recipient's contingent obligation to pay estate taxes that would be owed if the donor were to die within three years of making the gift.

Going back to the original example, suppose you'd like to take advantage of the net gift technique, but you'd like your son to enjoy the benefits of the full $1 million gift. It's possible for you to finance the net gift by lending your son the $285,714 he needs to cover the gift tax liability. To ensure that the loan is respected by the IRS, and not challenged as an additional gift, it's important to charge interest at the applicable federal rate (AFR) or higher, and to execute a written promissory note.

High, But Not Unlimited

The lifetime gift tax exemption is high — $11.7 million in 2021 — but some individuals have already reached that limit. If that's your situation, net gifts and net, net gifts may be an option. But to execute these strategies, it's important to work with experienced estate planning advisors to avoid unnecessary IRS scrutiny.

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