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How to give ‘net gifts’ to family members in a pinch

by on
in Small Business Tax,Small Business Tax Deduction Strategies

You might decide to reduce your taxable estate through lifetime gifts—and quickly. But you’d also like to avoid a hefty gift tax on amounts above the $1 million lifetime gift tax exemption and annual gift tax exclusion ($13,000 per recipient in 2010).

Strategy: Consider “net gifts” to family members. The recipient pays any gift tax due on the transfer. With this simple arrangement, you can reduce your estate with a reduced tax cost. The recipient pays the resulting gift tax but comes out ahead.

A net gift may not be as efficient as, say, a family trust, but it can be a quick fix for affluent individuals. Remember: The maximum gift tax rate is scheduled to rise to 55% in 2011 unless Congress takes action soon.

Here’s the whole story: For tax purposes, a “net gift” is defined as a gift in which the recipient agrees to pay the resulting gift tax as a condition of the gift. Therefore, the gift’s value is reduced to reflect the payment.

The amount of the gift tax for a net gift is based on the following formula: the actual gift divided by the sum of one plus the gift tax rate. (IRS Revenue Ruling 75-72)

Example: You give a $1 million cash “net gift” to your daughter in December 2010. For simplicity, we’ll assume that you have no annual gift tax exclusion or lifetime gift tax exemption available.

Under the IRS formula, the gift tax is $259,259. How it works: The top gift tax rate for 2010 is 35%, so $1 million divided by 1.35 (the sum of 1 + 35%) = $740,741. So your daughter winds up with a net gift of $740,741 ($1 million reduced by the gift tax bill of $259,259). Bottom line: The effective gift tax rate on your $1 million cash gift is only 25.93% instead of the expected 35%.

However, if the gift tax paid by your daughter exceeds the adjusted basis of the gifted property—for example, because you make a gift of highly appreciated stock instead of cash—she faces an income tax liability under a special “deemed sale” rule that we won’t get into here.

There are a number of other potential drawbacks to consider. Significantly, if the donor dies within three years of the net gift, any gift taxes paid by the recipient under a net gift deal are included in the donor’s estate.

Tip: Congress is still debating estate and gift tax reforms. We’ll continue to monitor it.

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