Transfer Taxes and Wealth Planning Chapter 14 Transfer Taxes and Wealth Planning

Learning Objectives Outline the structure of federal transfer taxes Describe the operation of the federal gift tax Summarize the operation of the federal estate tax Explain principles of wealth planning 2 2

Federal Transfer Taxes Common Features: Common tax rate schedule Unified credit Prevents taxation of all but large cumulative transfer “Exemption equivalent” is taxable amount of credit Unlimited charitable deduction Unlimited marital deduction for transfers to a spouse

Federal Transfer Tax Rates Tax base equal or over Not over Tentative tax plus Of the amount over 10,000 18% $10,000 $20,000 $1,800 20% $40,000 $3,800 22% $60,000 $8,200 24% $80,000 $13,000 26% $100,000 $18,200 28% $150,000 $23,800 30% $250,000 $38,800 32% $500,000 $70,800 34% $750,000 $155,800 37% $1,000,000 $248,300 39% $345,800 40%

Federal Gift Tax

Federal Gift Tax Levied on individual taxpayers for taxable gifts completed during a calendar year Transfers subject to gift tax: Imposed on intervivos gifts, lifetime transfers of property for less than adequate consideration Imposed once a gift has been completed (occurs when donor relinquishes control of the property and donee accepts the gift)

Valuation Property is included in the taxable gift at its fair market value at the date of the gift Fair market value “the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both have reasonable knowledge of the relevant facts”

Temporal interests Remainders and life estates Future interests are valued at present value, calculated by estimating the time until the present interest expires Present value calculation uses the §7520 interest rate published by the treasury

Example of temporal interests Ben transfers $1M of stock to the Junior Trust and directs it to pay income to Junior for his life and remainder to Georgia. How is the life estate valued if Junior is 5 years-old at the time of the gift and the Section 7520 rate is 5%? Based on Table S, the remainder is valued at $42,580 = (0.04258 x $1M). Hence, the life estate is valued at $957,420 = ($1M - $42,580)

Federal Gift Tax Gifts specifically excluded from the gift tax Incomplete and revocable gifts Payments for support obligations or debts Contributions to political parties or candidates Medical and educational expenses paid on behalf of an unrelated individual

Federal Gift Tax Annual exclusion Most gifts are eligible for an annual exclusion of $14,000 (2015) per donee per year Gifts of present interests qualify for the exclusion A present interest is a right to own and enjoy the property currently Certain gifts of future interests placed in trust for a minor can also qualify for the exclusion

Federal Gift Tax Calculating taxable gifts Gift-Splitting election increases the likelihood that gift tax will be reduced: Better use of the annual exclusions or unified credits Potential for lower tax rate on a portion of the gift Spouse must be married at the time of the gift and not divorce or remarry during the year Both spouses must consent to the election by filing a timely gift tax return Annual election that applies to all completed gifts

Federal Gift Tax Deductions are limited to the value of the gift after the annual exclusion Marital deduction Gifts to a spouse but not gifts of nondeductible terminable interests An interest that terminates and transfers to another upon an event or after a specified amount of time Charitable deduction No percentage limitation but qualifies for an income tax deduction No gift tax return necessary for gifts of entire interest

Federal Gift Tax Computation of the gift tax Prior taxable gifts + current taxable gifts Tax on cumulative gifts Purpose is to increase the tax base and thereby increase the marginal tax rate applying to current gifts Subtract gift tax on prior taxable gifts prevent double taxation of prior taxable gifts Tax is calculated using current rate schedule Unused unified credit (calculated using current rate schedule

Gift tax example Brian made a $7 million taxable gift this year. Previously he had made a $1 million taxable gift that was offset by the unified credit. What amount of gift tax is due on Brian’s gift? Tax ($8M of cumulative transfers) $ 3,145,800 Less current tax on prior taxable gifts - 345,800 Less Unused UC ($5.43M - $1M) - 1,772,000 Tax due on Brian’s taxable gift $ 1,028,000 Note that Brian’s cumulative taxable gifts are $2.57 over the exemption equivalent ($8M - $5.43M). The gift tax is a flat 40% over the exemption equivalent (40% x $2.57 = $1.028M).

Federal Estate Tax Designed to tax the value of property owned or controlled by an individual at death The Gross Estate has two components: Probate – Process of paying the debts of the decedent, and transferring the ownership of any remaining property to the decedent’s heirs Probate Estate – Property owned by a decedent (titled in the name of the decedent) at the time of the death

Federal Estate Tax

Federal Estate Tax The gross estate consists of: The probate estate plus Value of certain automatic property transfers that take effect at death Automatic transfers include joint ownership with right of survivorship. Property is valued at the fair market value at the date of the decedent’s death. Executor can elect to value the estate on an alternate valuation date, six months after death, if it reduces the gross estate and estate tax

Federal Estate Tax Automatic transfers included in the gross estate: Property owned by the decedent in joint tenancy with right of survivorship (tenants in common are included in the probate estate) Proceeds of life insurance paid due to the death of the decedent if either of two conditions is met: Decedent “owned” the policy Decedent’s estate or executor is the beneficiary of the insurance policy Transfers within three years of death These transfers are “grossed up” for the amount of gift taxes paid (if any)

Federal Estate Tax

Federal Estate Tax Taxable estate is the gross estate reduced by: Administrative expenses, debts, losses, and state death taxes Marital and charitable deductions Computation of estate tax Adjusted taxable gifts Are prior gifts (not already included in the gross estate) Objective is to allow estate tax base to reflect all transfers

Federal Estate Tax Unified credit Eliminates transfer taxes on a estates with minimal lifetime and testamentary transfers Measured by current tax on exemption equivalent Amount of cumulative taxable transfers that can be made without exceeding the unified credit Credit is applied after reducing the total tax on cumulative transfers for taxes payable on adjusted taxable gifts A surviving spouse whose deceased spouse died without using their unified credit is entitled to the unused credit (a deceased spousal unused exclusion or DSUE)

Applicable Exclusion Amount Federal Estate Tax Year of gift/death Applicable Exclusion Amount 1986 $500,000 1987–1997 600,000 1998 625,000 1999 650,000 2000–2001 675,000 2002–2003 1,000,000 2004–2005* 1,500,000 2006–2008* 2,000,000 2009–2010 3,500,000 2011 5,000,000 2012 5,120,000 2013 5,250,000 2014 5,340,000 2015 5,430,000

Estate tax example Ed died this year with a taxable estate of $10 million. In 2011 Ed made a $1 million gift that was offset by the unified credit. What is the amount of estate tax due on Ed’s estate? Tax ($11M of cumulative transfers) $ 4,345,800 Unified credit (exemption of $5.43M) - 2,117,800 Tax due on Ed’s estate $ 2,228,000 Note that Ed’s estate is $5.57M over the exemption equivalent ($11M - $5.43M). The estate tax is a flat 40% over the exemption equivalent (40% x $5.57 = $2.228M).

Wealth Planning Concepts The generation-skipping tax (GST) Supplemental tax designed to prevent the avoidance of transfer taxes through transfers that skip a generation of recipients Not widely applicable as it does not apply to transfers that qualify for an annual gift tax exclusion Income tax considerations

Wealth Planning Concepts Transfer tax planning techniques Serial gifts Strategy saves gift taxes by converting a potentially large taxable transfer into multiple smaller transfers that qualify for the annual exclusion DSUE Allows use of unused exemption of deceased spouse Bypass provisions can accomplish same objective with more control over assets The Step-up in tax basis