Transcript Chapter 12: Wealth Transfer Taxes

Chapter 12
Wealth Transfer
Taxes
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History
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The U.S. has had an estate tax since 1916
and a gift tax since 1932
In 1976, Congress enacted the unified
transfer tax system with unified graduated tax
rates, ranging from 18% to 55%
In 2001, Congress voted to reduce top rates
gradually until they reach 45% in 2007
Estate tax will be repealed in 2010, but gift tax
will be retained (sunset provisions
automatically reinstate prior law in 2011)
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Transfer Tax Features
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Tax is assessed on transferor (donor or estate),
not recipient
Base for tax is fair market value of property
transferred
Gift tax is cumulative over lifetime
Gifts given in later years are taxed at higher
marginal tax rates
Total taxable gifts cause the decedent’s estate to
be taxed at higher marginal tax rates
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Major Exclusions
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Annual gift tax exclusion is $11,000 per donee
per year
 If all gifts are less than exclusion, no gift tax return
has to be filed
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Unified credit – lifetime transfer tax exclusion
The 2005 unified credit for an estate is
$555,800 which is equivalent to tax on $1.5
million (referred to as exemption equivalent)
For lifetime gifts, the exemption equivalent is $1
million
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Transfers Subject to the Gift Tax
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Gifts made directly or in trust
Includes gifts of all types of property whether
real, personal, tangible, or intangible
Services are not taxable
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A gift could result from the creation of a trust,
the forgiveness of debt, or the assignment of
benefits in a life insurance policy
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Transfers for
Insufficient Consideration
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A transfer is subject to gift tax if the value of
the property transferred exceeds the value of
money or other consideration given
Gift = difference between the sales price and
the FMV on the date of the transfer
A transfer made in a bona fide business
transaction with no donative intent is not a gift
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Joint Property Transfers
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If funds are placed into a joint bank account
by a donor in the name of the donor and one
or more other persons, no current gift occurs
A gift occurs when one party withdraws an
amount in excess of the amount that person
deposited
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A gift occurs when an individual adds another
person’s name to the title of real property
Gift = value of other person’s interest
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Life Insurance Transfers
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Naming someone as beneficiary of a life
insurance policy is not a gift
When all rights of ownership are assigned to
another, a gift equal to the cost of a
comparable policy is made
 Ownership rights include the right to borrow
against policy, withdraw the cash surrender
value, and change the beneficiary
Paying the premium on a policy owned by
another is a gift equal to the premium paid
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Transfers to a Trust
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A trust is a legal arrangement involving three
parties
1. Grantor – the one who transfers assets that
become the corpus or principal of the trust
2. Trustee – the one who holds legal title to the
assets and makes investment decisions
3. Beneficiary – the one who receives the legal
right to the beneficial enjoyment of income or
corpus
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Transfers to a Trust
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Income beneficiary – the one who has the
right to receive income generated by the trust
assets
Remainder interest – the one who has the
right to receive trust assets upon termination
of the trust
Parents who want to transfer assets to a
minor child can use a Uniform Transfers to
Minors Act (UTMA) account
Grantor-parent can be trustee and maintain
control over the property
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Cessation of Donor’s Control
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A transfer is not a gift if the donor retains an
interest in the transferred property
 For example, if the donor retains the right to
change trust beneficiaries or decide how much
beneficiaries will receive
A transfer to a revocable trust is not a gift (but
actual transfer of income is a gift)
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Transfer of assets into an irrevocable trust is
a gift
A trust is irrevocable when the grantor gives
up all future control
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Transfers Excluded from Gift Tax
1. Transfer of marital property pursuant to a
divorce
2. A transfer to meet support obligations (as
determined by state law)
3. Direct payment of medical or tuition
expenses
 Payment must be made directly to the
educational institution or the person providing
medical care
 Payment for room, board, and books is a gift
4. Contributions to political organizations
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Valuation of Gift Property
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Gifts are taxed on FMV at the date of the gift
FMV – price that would be arrived at by a
willing buyer and willing seller in an arm's
length agreement when neither is under
compulsion to buy or sell
FMV is not a distressed sale price or
wholesale value
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Stock or securities sold on an established
securities market are valued at the average
of the high and low price on the date of the
gift
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Annual Gift Exclusion
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Annual gift tax exclusion ($11,000) only
allowed for gifts of present interest
Present interest includes
Outright transfers
Life estates (right for life)
Term certain interests (right for specific time)
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Future interests are not eligible
Remainder interests
Reversions
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Gifts to Minors
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Section 2503(c) minor’s trusts qualify for
annual gift tax exclusion if:
1) Trustee may pay out income and/or trust
assets before beneficiary reaches 21
2) Remaining assets and income must be
distributed to the child when the child
reaches age 21 (or to the estate if minor dies
before age 21)
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Gifts to Minors
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Crummey trust – transfers qualify for annual
exclusion if the trust has an annual demand
provision (no distribution required at 21)
Transfers to Coverdell education savings
accounts qualify for annual exclusion
Transfers to qualified tuition programs (Section
529 plans) eligible for annual exclusion
 Election can be made to spread gift over 5 years;
thus up to $55,000 can be transferred at one time
with no gift tax consequences (provision can be
used only once every 5 years)
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Gift Splitting
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Allows spouses to combine their $11,000
exclusions; by doing so, they can exclude
$22,000 per donee per year by treating each
gift as if half was made by each spouse
Requires consent of both spouses
Applies to all gifts made during that year (or
during time they are married)
Requires filing a gift tax return
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Gift Tax Deductions
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Charitable deduction – unlimited gifts to
qualified charitable organizations (after
subtracting annual exclusion)
Marital deduction – unlimited gifts to spouse
(after subtracting annual exclusion)
Similar deduction allowed for estates; thus no
estate tax owed if entire estate left to spouse
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Tax Consequences for
Donees
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Donor’s adjusted basis (and holding period)
generally carries over to the donee
If appreciated property, basis increased by
proportionate amount of gift tax paid on
appreciation
If FMV is less than basis, lower FMV is used
to determine loss on subsequent disposition
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Kiddie Tax
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Under the kiddie tax, unearned income
(in excess of $1,600) of children under
age 14 is taxed at their parents’
marginal tax rate
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Education Savings Plans
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Earnings are not currently taxed and are never
subject to tax to the extent income is used for
qualified education expenses
Section 529 qualified tuition plan
No annual limit on contributions (some states cap
the contribution amount equal to 4 years tuition at
the most expensive institution in the state)
Can change beneficiary
Donor can cash out account by paying income tax
+ 10% penalty
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Education Savings Plans
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Coverdell education savings accounts (ESA)
Annual contribution limit of $2,000 (phased out
as modified AGI exceeds $95,000 if single or
$190,000 for married couples)
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Donor can contribute to both types of savings
plans for same child in same year
Other relatives (grandparents) can also use
these plans to save for a child’s education
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The Estate Tax
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The estate tax is a tax levied on the right of a
decedent to transfer of property to
beneficiaries or heirs upon his or her death
An estate is created at an individual’s death
to own and manage the decedent’s property
until ownership of the property is transferred
to the beneficiaries or heirs
Estate taxes are levied on the value of all
property owned by a decedent and
transferred at the decedent’s death
The estate pays the tax
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The Taxable Estate
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Steps to compute the taxable estate
1. Identify and value the assets included in
the gross estate
2. Identify the deductible claims against the
gross estate and deductible expenses of
estate administration
3. Identify any deductible bequests
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The gross estate includes all property and
property interests of the decedent
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Probate
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Probate – the process under state law by
which a will is declared legally valid and
decedent’s property is transferred to the
beneficiaries
Probate estate includes only the property
governed by the will (or the state’s intestacy
laws if there is no valid will) and does not
include property transferred by law
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Gross estate includes property that transfers
by will and by law
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Living Trust
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One strategy for avoiding probate costs is to
use a living trust that holds title to all of the
individual’s assets and specifies how they are
transferred at death
The will only needs to designate the treatment
of any asset not in the trust
Unlike a will, a living trust is not a public
document
Property in a living trust must be included in
the gross estate
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The Gross Estate
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Gross estate includes all property in which
the decedent had an interest and may include
some items not actually owned by the
decedent at death
Gifts with strings attached (decedent retained
right to income or right to designate who may
enjoy property)
Transfers in which the decedent possessed
the right to alter, amend, revoke, or terminate
the terms of the transfer
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Life Insurance Proceeds
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Included in the gross estate if:
Decedent’s estate is the beneficiary or
Decedent possessed any incident of ownership
at death (power to change the beneficiary,
surrender or cancel the policy, assign the policy,
revoke an assignment, pledge the policy for a
loan, or obtain a loan from the insurer against
the surrender value of the policy)
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Insurance is included in the estate if it was
transferred by gift within 3 years of death
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Valuation Issues
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The gross estate includes the value of all
property, regardless of location, as of date of
death
Alternative valuation date is 6 months after
the decedent’s date of death
If elected, it applies to all assets
Gross estate and estate tax must both be
reduced to use the alternate date
If assets are sold prior to alternate date, they
are valued at date of sale
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Valuation Issues
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Market price method – used for stocks,
bonds, and real estate
Stocks valued at average of their high and low
selling prices on valuation date
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Actuarial valuation used for annuities, life
estates, terms certain and remainder interests
Capitalization of earnings used when valuing
businesses
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Estate Deductions
1. Any debts of the decedent and claims against
property included in the gross estate
2. Funeral expenses and administrative costs of
settling the estate
3. Casualty and theft losses incurred during the
administration of the estate
4. Bequests to charitable organizations
5. Property transferred to surviving spouse
 Qualified terminal interest property (QTIP) trust
allows the decedent to exclude value of property
transferred in trust to spouse
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GSTT
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Generation skipping transfer tax applies
a separate flat tax at the highest transfer
tax rate (47%) when a transfer skips a
generation
A direct transfer from grandparent to
grandchild is a generation skip
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$1.5 million GSTT exemption is
available to each grantor (2005)
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Benefits of Planned Giving
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Transfer of investment property (bonds)
allows a family to shift income to lowerbracket family members
 Offers few transfer tax benefits if there are small
differences between current and future value
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Transfer of equity interest in flow-through
entity offers both current income tax and
future transfer tax benefits
Buy-sell agreement
Gift-leaseback arrangement
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Advantages of Lifetime Gifts
1. Shield post-gift appreciation from estate
taxes (taxed on date of gift value)
2. Take advantage of annual exclusion and
gift-splitting
3. Nontax advantages of trusts
 Protects property from creditors
 Shields assets from public scrutiny
 Allows ease of management for multiple
beneficiaries
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Disadvantages of Lifetime Gifts
1. Carryover basis on gift property
 If donor had retained property until death,
basis would have been stepped up to FMV
2. Early payment of transfer taxes
 Estate tax exemption increases to $2 million
for 2006-2008 and $3.5 million in 2009 while
lifetime gift exemption remains at $1 million
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Fiduciary Income Tax Issues
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The decedent’s final income tax return
extends from date of the last tax return to the
date of death
Income in respect of decedent (IRD) –
income earned by cash-basis decedent but
not received prior to death is taxed to
whoever receives it
Examples: unpaid salary, interest, dividends,
retirement plan income
Decedent’s basis carries over and character of
income also carries over
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Fiduciary Income Tax Issues
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Deductions in respect of decedent (DRD) –
expenses or liabilities incurred by cash-basis
decedent but not paid prior to death are
deductible by party legally required to pay
them (usually estate)
Examples: property and state income taxes
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Basis Issues
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Basis of inherited property is its fair market
value as of the valuation date used for estate
tax purposes
The basis rules will change in 2010 (if estate
taxes are repealed) to a modified carryover
basis rule
$1.3 million of basis can be added to certain
assets
$3 million of basis can be added to assets
transferred to a surviving spouse
Basis increase cannot increase property to
more than FMV
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Income Taxation of
Trusts and Estates
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Fiduciaries (estates and trusts) are taxed
following a modified conduit approach that
taxes the fiduciary only on income it retains,
not on income that it distributes to the
beneficiaries
Beneficiaries are taxed on income distributed
to them
Character of income is determined at fiduciary
level and retains this character when
distributed to beneficiaries
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Fiduciary Income Tax Rates
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2005 Rates
15% on $0 - $2,000
25% on $2,001 - $4,700
28% on $4,701 - $7,150
33% on $7,151 - $9,750
35% over $9,750
Because beneficiaries are usually in lower
marginal tax brackets, distributing the income
annually to beneficiaries usually results in lower
taxes overall
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Computing Taxable Gifts
Includible current gifts
Plus: Half of spouse’s gifts (if gift splitting)
Less: Half of taxpayer’s gifts (if gift splitting)
Less: Annual exclusions
Less: Charitable and marital deductions
Equals: Taxable gifts for current period
Plus: Taxable gifts in previous periods
Equals: Cumulative taxable gifts
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Computing Gift Tax Payable
Gift tax on cumulative taxable gifts
Less: Gross gift tax on previous taxable gifts
Less: Available unified credit
Equals: Gift taxes payable on current period’s gifts
Gift tax return due by April 15 of following year
(eligible for same extension as for individual
income tax return)
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Gift Tax Return
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Form 709 gift tax return must be filed if
there were any of the following transfers
1) Transfers of present interests in excess of
the annual exclusion ($11,000)
2) Transfers of future interests
3) Transfers to charitable organizations in
excess of annual exclusion
4) Transfers with gift splitting elected
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Computing Estate Tax
Gross estate
Less: Deductible expenses, debts, taxes, losses
Less: Charitable deduction
Less: Marital deduction
Equals: Taxable estate
Plus: Adjusted taxable gifts - prior periods
Equals: Tax base
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Computing Estate Tax
Gross estate tax
Less:
Less:
Less:
Equals:
Gift tax on prior gifts
Unified credit
Other allowable credits
Net estate tax liability
Estate tax return, Form 706, due 9 months after
death (6 month extension possible)
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Kiddie Tax
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Under the kiddie tax, unearned income (in
excess of $1,600) of children under age 14 is
taxed at their parents’ marginal tax rate
First $800 covered by standard deduction
Second $800 (and all earned income) taxed at
child’s tax rates
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Computing the Kiddie Tax
1. Determine the child’s taxable income
2. Calculate the tax on the child’s net unearned
income in excess of $1,600 at the parents’
marginal tax rate
3. The child’s remaining taxable income is
taxed at the child’s normal tax rates
4. The taxes determine in (2) and (3) are
summed to determine the child’s gross
income tax liability
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Fiduciary Income Taxation
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Fiduciary gross income is computed using
rules similar to individual income taxation
Deductions allowed for expenses of
producing taxable income, depreciation,
administrative expenses, and charitable
contributions
Simple trusts allowed $300 exemption
Complex trusts allowed $100 exemption
Estates allowed $600 exemption
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Types of Trusts
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Simple trust – must distribute all of its
accounting income annually to its beneficiaries
and cannot make charitable contributions
Complex trust – any trust that is not a simple
trust
 Not required to distribute all their accounting income
each year allowing trust principal to accumulate
 Can take tax deduction for making charitable
contributions
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DNI
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Distributable net income (DNI) is the current
increase in value available for distribution to
income beneficiaries
DNI determines the fiduciary’s maximum
distribution deduction
DNI determines beneficiary’s maximum
taxable income
Character is retained so beneficiaries do not
pay tax on tax-exempt income
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Fiduciary Filing Requirements
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A trust is required to file a Form 1041 by April
15 of the following calendar year if it has
gross income of $600 or more
Any estate with gross income of $600 or more
is required to file a Form 1041 by the 15th day
of the 4th month following the close of its tax
year
Beneficiaries report their share of income
based on the fiduciary’s tax year that ends
within the beneficiary’s tax year
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Distributions to Beneficiaries
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When property is distributed to trust
beneficiary, generally no gain or loss is
recognized by the trust for difference between
FMV and basis
Beneficiaries use trust’s adjusted basis
If property satisfies a required income
distribution, distribution deduction limited to
lesser of property’s basis or its FMV
(beneficiaries still use basis)
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Distributions to Beneficiaries
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Trustee can elect to recognize gain on
distribution of appreciated property
Beneficiary’s basis is FMV
If trust has unused capital losses, it can net
these losses against any capital gains
resulting from the election
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The End
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