Make Net Gifts Now, Save Later: Reduce Estate Tax Liability by Having Donees Pay Gift Taxes

Estate Planner Nov-Dec 1997
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Making lifetime gifts to reduce estate tax liability is an underused estate planning technique. Why? Perhaps because you don’t want to use your remaining resources to pay the gift taxes. You may, however, want to consider gifting property on the express condition that the donee pay the gift tax. These arrangements are termed “net gifts.”

Net gifts can significantly reduce estate tax at your death because you remove from your taxable estate the gifted property itself, the tax on the gifted property (assuming you outlive the transfer by at least three years) and all future appreciation on the property.

Determining the Net Gift’s Value¬†

The value of the net gift for gift tax purposes is the fair market value of the asset less the gift tax payable. Because the amounts of both the gift and the gift tax are mutually dependent, an algebraic formula or an appropriate software program is necessary to determine the gift.

Capital Gains Tax Consequences

Net gifts can have capital gains tax consequences. The donor is essentially receiving consideration for the transfer in the amount of the gift tax to be paid by the donee. The Internal Revenue Service (IRS) has taken the position that the donor receives an economic benefit if the gift tax due exceeds the donor’s basis.

For example, assume the value of the gift property is $100,000 with a tax basis of $20,000, and the gift tax due on the gift is $30,000. The IRS deems that by receiving the $30,000 tax liability from the donee in exchange for the gift property, the donor has realized a $10,000 gain ($30,000 gift less $20,000 basis equals a $10,000 gain). This gain will be subject to capital gains tax.

Consequently, a donor should gift property with a tax basis equal to or slightly higher than the gift tax liability on the transfer. Another way to avoid potential capital gains tax is to make the gift but hold back sufficient funds to pay the gift tax. This approach works best when gifting cash or other liquid assets.

Leveraging Net Gifts

As is any lifetime gift, a net gift is particularly useful for transferring assets that are likely to appreciate significantly in the future. This appreciation can then take place in the hands of a younger generation. If the donee does not have the funds to pay the gift tax, he or she may be able to borrow the needed amounts by using the gifted property for collateral.

Will a Net Gift Benefit You?

Having the donee assume the liability for payment can allow you to reduce your estate tax burden. If you would like help determining whether this technique will benefit you, give us a call.

 

Case Study: No Gift vs. Net Gift*

Jane intends to leave her entire $30 million estate to her daughter, Mary. At Jane’s death, an estate tax of $16.5 million will be due, leaving Mary with assets totaling $13.5 million.

If, instead, Jane makes a lifetime gift to Mary of $10 million, and conditions the gift on Mary paying the gift tax, total transfer taxes will be less. Of the $10 million Jane transfers to Mary, $6,811,290 will be the value of the gift and $3,188,710 will be the gift tax owed on the gift. At Jane’s death, the estate tax due will be $11,558,000. Mary will have paid a total of $14,751,710 in transfer taxes — more than $1.75 million less than if no net gift had been made.

*This example is based on 1997 estate and gift tax rates and exemptions.

Total Transfer Taxes Paid

No Gift Net Gift of $10,000,000
Gift tax $3,188,710
Estate tax $16,500,000 $11,558,000
Total tax $16,500,000 $14,746,710
Additional tax $1,753,290

Amount Received by Mary

No Gift Net Gift of $10,000,000
From gift $6,811,290
From estate $13,500,000 $8,442,000
Total $13,500,000 $15,253,290
From tax Savings $1,753,290