If you’re concerned about the impact of transfer taxes on your gifts, consider making “net gifts” to your loved ones. A net gift is a gift the recipient agrees to pay the gift tax to reduce the gift value for tax purposes. It may also be possible to reduce its value further through the “net, net gift” technique.

The net gift technique in action

The easiest way to demonstrate the benefits of a net gift is through an example. Suppose you’d like to make a $1 million gift to your adult son. For purposes of this example, also assume that you’ve exhausted your federal gift and estate tax exemption amount. That makes the gift 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, the amount of tax would reduce the value of the gift. That would then reduce the amount of gift tax owed.

Don’t get caught up in an endless loop of calculating the tax, reducing the gift’s value, and recalculating the tax. 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 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.

Using a net gift technique reduces the effective tax rate on the $1 million transfer from 40% to only 28.57%. Note that if the gift is appreciated assets instead of cash, the recipient’s payment of the tax liability can result in capital gains taxes for the donor.

Reduce your gift tax rate

It may be possible to reduce the effective gift tax rate further using a net, net gift. In addition to assuming liability for gift taxes, the recipient agrees to pay the estate tax liability that might arise. The “three-year rule” is to blame.

Under that rule, gifts made within three years of death are pulled back into the donor’s estate and subject to estate taxes. However, the U.S. Tax Court has effectively allowed the net, net gift technique. Therefore, the value of a gift is to be reduced by the actuarial value of the recipient’s contingent obligation to pay estate taxes if the donor were to die within three years of the gift.

If you’re considering the net gift technique, consult with us before taking action.Contact our RRBB accountants and advisors right away.

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