September 22, 2015

On April 17, 2007, Ms. Jean Steinberg, 89 years old, entered into a binding gift agreement (net gift agreement) with her daughters (the “donees”). In the net gift agreement she agreed to make gifts of properties to her daughters. In exchange, her daughters agreed to assume and to pay any Federal gift tax liability imposed as a result of the gifts. The daughters also agreed to assume and to pay any Federal or State estate tax liability imposed under section 2035(b) as a result of the gifts in the event that Ms. Steinberg passed away within three years of the gifts. The gift is described as a “net, net gift” because the donees agreed to pay both the resulting gift tax and any section 2035(b) estate tax.1

The amount of the gift is the amount by which the value of the property transferred exceeds the value of consideration received in money or money's worth. Thus, if a donor makes a gift subject to the condition that the donee pay the resulting gift tax, the amount of the gift is reduced by the amount of the gift tax. Under section 2035(b) a decedent's gross estate is increased by the amount of any gift tax paid by the decedent or the decedent's estate on any gift made by the decedent during the three-year period preceding the decedent's death. The donor reduces the value of the gift by the amount of the tax because the donor has received consideration for a part of the gift equal to the amount of the applicable gift tax.

The fundamental question posed by this case is the fair market value of the property rights transferred under the net gift agreement. The fair market value of transferred property must take into account any restrictions or conditions limiting the property's marketability, including those imposed by the donor.

A willing buyer of the property rights pursuant to the net gift agreement would recognize that to obtain the properties, he or she would also have to assume both the gift tax and the section
2035(b) estate tax liabilities associated with the transfer. The gift tax and the section 2035(b) estate tax liabilities did not exist before the net gift agreement. These liabilities arose as a result of the net gift agreement.

My report began by establishing the gross value of the gifts that the petitioner transferred to the daughters under the net gift agreement. I testified that I used the $109,449,307 gross value calculated in the appraisals that the petitioner submitted with her gift tax return. The gift tax liability amounted to $32,012,711.

I then calculated the value of the section 2035(b) estate tax liability. IRS actuarial tables were used to calculate the probability that the petitioner would die within each of the three years after the date of the net gift agreement. The annual mortality rate for year 1, year 2, and year 3 was 13.84%, 13.04%, and 12.13%, respectively. The present value of the probability adjusted mortality was determined by use of the section 7520 interest rate applicable on the valuation date. Next, I used the effective State and Federal estate tax rates for each of the three years and multiplied them by the gift tax included in the estate under section 2035(b).2 Because the estimated estate taxes is also a component used in calculating the net gift (and the net gift is the amount used to derive the estate taxes), the determination of the final amount of the present value of the contingent liability is a circular calculation whose answer is only resolved after multiple recalculations (iterations) of the involved mathematical steps. In Steinberg, the daughters' assumption of the section 2035(b) estate tax liability reduced the value of the combined gift by $5,838,540.

One interesting point raised at trial by the IRS was whether or not the section 7520 rate was a “market” rate or not. The answer is that it is usually not a market rate since the original purpose of the section 7520 rate was to relieve taxpayers of the burden of having to do market studies for transactions using this section. However, I pointed out that it would be inappropriate to assume that the rate of return conveyed by the assumption of the contingent liability was entirely based upon the section 7520 rate. Such an analysis would take into account the combined effects of the probability adjustment and the present value factor.

 

1 Mr. Frazier coined the term “net, net gift” in an article on this topic published in 2008. (Michael S. Arlein and William H. Frazier. The Net, Net Gift. Trusts & Estates. August, 2008: 25-34. Print)

2 At the Valuation Date, existing tax law set the Federal estate tax rate in 2010 at zero percent. Much to everyone’s surprise that is, in fact, what the rate turned out to be.