Lifetime giving is a smart strategy to reduce your taxable estate. However, if you’ve exhausted your $12.06 million federal gift and estate tax exemption, your gifts may be fully taxable at the 40% rate. In this case, consider making “net gifts.” This technique requires your recipient to agree to pay the gift tax as a condition of receiving the gift, thus reducing the gift’s value for gift tax purposes.
Benefits of a net gift
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.
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 by assuming that you give your son $1 million and that he agrees to pay $285,714 in gift tax. 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.
Double down with a net, net gift
It may be possible to reduce the effective gift tax rate even further by using a net, net gift. Using 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.” Under that rule, gifts made within three years of death are pulled back into the donor’s estate and subject to estate taxes.
Going back to our 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.
Meet with your estate planning advisor
Making net gifts may make sense if you’ve used up your gift and estate tax exemption amount. But be aware that it’s important to properly document the transactions to avoid IRS scrutiny. Your estate planning advisor can help your net gifts pass muster with the IRS.