Okay, I know what you are thinking – what is a “net, net gift?”
Most estate planners know that a “net gift” is a gift transfer when the donee assumes responsibility for applicable gift taxes. Normally, a donor is responsible for gift taxes on a gift, and they are paid from separate assets or funds of the donor. If it is a net gift, the donee pays the taxes – usually, but not always, from the assets that are gifted. Since the donor is receiving consideration for the gift (the payment of tax paid by the donee), the amount of the gift subject to gift tax is reduced.
A “net, net gift” adds in a second payment obligation. Here, the donee also agrees to pay any increase in estate taxes imposed on the donor’s estate under Code §2035(b) relating to the gift. That provision adds back to the gross estate any gift taxes paid on a gift if the donor dies within 3 years of the gift. Remember that there is an advantage to making gifts and paying gift taxes, instead of holding the assets until death and paying estate taxes. If a gift tax is paid by the donor, the tax is gone and no gift or estate tax is paid. If the gift is not made, the estate tax on the same transferred assets are still included in the gross estate and are thus subject themselves to estate tax. Code §2035(b) was enacted to prevent death bed gifts from obtaining this gift tax benefit – if death occur within 3 years the gift tax is subject to estate tax so no transfer tax benefit arises from the gift.
The Tax Court had previously ruled in McCord v. Commissioner, 120 T.C. 358 (2003) that a net, net gift payment obligation could not reduce the value of a gift for gift tax purposes. The Court was reversed by the 5th Circuit Court of Appeals in Succession of McCord v. Commissioner, 461 F.3d 614 [98 AFTR 2d 2006-6147] (5th Cir. 2006), which allowed the reduction. Since the current case is not a 5th Circuit case, the Tax Court is not bound by the Court of Appeals in Succession of McCord under the Golsen rule. Nonetheless, the Tax Court discarded its prior analysis in McCord and allowed a gift tax value reduction for the Code §2035(b) estate tax assumption element.
Here are some interesting take-always from the opinion:
a. Computing the actuarial value of the assumption of the contingent obligation to pay estate taxes if the donor does not survive three years is not simple. For those with an interest, the petitioner’s attorney and her appraiser wrote an article on the subject which was referenced in the opinion: Michael S. Arlein & William H. Frazier, “The Net, Net Gift”, 147 Tr. & Est. (Arlein & Frazier) 25 (2008).
b. A relatively large gift is needed to obtain a material reduction from the net, net gift. A large gift was involved in the case – total gifts of more than $71.5 million. The value of the estate tax assumption obligation (and thus the gift tax value redction) was determined to be approximately $5.8 million.
c. If the payment of consideration is “too speculative,” then no reduction in the value of the gift should apply. The Court of Appeals in McCord applied the willing buyer/willing seller test to this determination by asking whether a willing buyer would insist that the seller factor the contingency into the price – if yes, then it should be recognized as consideration reducing the amount of the gift.
d. If actuarial science cannot reasonably determine a value for a contingency, then it will likely be ignored. The opinion cited Robinette v. Helvering, 318 US 184, wherein the Supreme Court disregarded a contingency when the factors to be considered in fixing the values of the contingent remainders on the date of the gifts included: (1) whether a daughter would marry; (2) whether a daughter would have children; and (3) whether those children would reach the age of 21. The Supreme Court noted: "[W]e have no reason to believe from this record that even the actuarial art could do more than guess at the value here in question.”
e. The computation here is not beyond the reach of actuarial science. The court noted:
In this case, as in McCord, the contingency in issue is whether petitioner would survive three years after the date of the gift. Like the contingency in Smith, this contingency is simple and based on the possibility of survivorship; it is not complex like the contingency in Robinette, which depended on multiple occurrences.
f. The fact that estate tax rates and exemption amounts may fluctuate over the three year term of Code §2035(b) does not create enough uncertainty as to make it impossible to value the contingent tax payment obligation.
g. One of the theories applied in a net gift situation is the ‘estate depletion theory.’ Under the estate depletion theory, a donor receives consideration in money or money's worth only to the extent that the donor’s assets have been replenished. The IRS argued that the donor obtained no replenishment, only the donor’s estate. The Court equated the donor and the donor’s estate for this purpose, rejecting the IRS argument.
h. The dissenting opinion did make an interesting policy argument that favors the IRS. Code §2035(b) was intended to put a donor who makes a gift subject to gift tax the day before he dies on the same footing as he would be if he did not make the gift and thus the gifted assets are instead subject to estate tax. By allowing a reduction in the amount of the gift for the contingent payment obligation, the amount of the gift tax is reduced, and thus the amount of the add-back under Code §2035(b) is effectively reduced. Thus, there is still a benefit to making a death bed gift notwithstanding Code §2035(b) if a net, net gift is made – and as such, the operation and purposes of Code §2035(b) can be partially subverted.
Steinberg v. Comm., 141 TC No. 8 (9/30/13)
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