Lifetime giving is a smart strategy to reduce your taxable estate, but the gift tax rate of 40% is steep. If you’ve used up your $5.43 million gift and estate tax exemption and you’d like to potentially reduce your effective gift tax rate to 28.6%, consider making net gifts. This technique requires the 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.

A net gift in action

Here’s an example that illustrates the net gift’s tax-saving power. Bob plans to make a $1 million gift to his daughter, Elizabeth. He’s already used up his gift and estate tax exemption and wants to minimize the tax. At the current top gift tax rate of 40%, an outright gift would result in a $400,000 tax bill.

If Elizabeth agrees to pay the gift tax, the value of the gift — and, therefore, the gift tax liability — is reduced. There’s a simple formula to calculate the tax on a net gift: gift tax = tentative tax / (tax rate + 1). The tentative tax is the amount that would have been due if the gift hadn’t been structured as a net gift (in this case $400,000). Applying this formula to the example, the gift tax would be $400,000 / 1.4, or $285,714 (for an effective rate of about 28.6%).

To ensure that Elizabeth receives the full $1 million gift, Bob uses a “financed net gift.” He makes her a $285,714 loan to cover her tax obligation, bearing interest at the applicable federal rate (AFR) and documented by a written promissory note. Lately, AFRs have been low.

One caveat: The gift tax liability assumed by the recipient constitutes consideration in exchange for the gift. If the gift consists of appreciated property, a net gift or financed net gift can result in capital gains tax liability for the person making the gift.

Suppose, in the previous example, that instead of cash Bob gives Elizabeth real estate with a fair market value of $1 million and a cost basis of $200,000. If Elizabeth pays $285,714 in gift tax, the excess of that amount over Bob’s basis ($85,714) is a taxable capital gain to Bob. One way to avoid capital gains tax is to enter into a financed net gift transaction with a grantor trust rather than the ultimate beneficiary.

Tax Court approves enhanced strategy

You can enhance the benefits of a net gift by having the recipient assume the potential estate tax liability that might arise under Internal Revenue Code Section 2035(b). This section provides that a gross estate is increased by the amount of gift tax paid on any gifts made during the three-year period ending on the date of death. It’s designed to prevent people from using deathbed gifts to reduce transfer taxes.

Historically, the Tax Court has rejected this strategy, finding that the estate tax liability, which may or may not arise, is speculative. But in a recent case — Steinberg v. Comm’r — the court reversed its position, permitting taxpayers to reduce the value of gifts by the actuarially determined value of the recipient’s contingent obligation to pay any tax liability that might arise under Sec. 2035(b).

Put pen to paper

When making net gifts, the recipient (or, in the case of a gift in trust, the trustee) must sign a written agreement when the gift is made that he or she will assume liability for gift and estate taxes. In addition, the recipients should seek separate estate planning attorneys before signing the agreement.