Chapter 12 Wealth Transfer Taxes

History 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from 18% to 55% In 2001, Congress voted to reduce top rates gradually until they reach 45% in 2007 Estate tax will be repealed in 2010, but gift tax will be retained (sunset provisions automatically reinstate prior law in 2011)

Transfer Tax Features 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

Major Exclusions 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 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

Transfers Subject to the Gift Tax Gifts made directly or in trust Includes gifts of all types of property whether real, personal, tangible, or intangible Services are not taxable A gift could result from the creation of a trust, the forgiveness of debt, or the assignment of benefits in a life insurance policy

Transfers for Insufficient Consideration 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

Joint Property Transfers 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 A gift occurs when an individual adds another person’s name to the title of real property Gift = value of other person’s interest

Life Insurance Transfers 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

Transfers to a Trust A trust is a legal arrangement involving three parties Grantor – the one who transfers assets that become the corpus or principal of the trust Trustee – the one who holds legal title to the assets and makes investment decisions Beneficiary – the one who receives the legal right to the beneficial enjoyment of income or corpus

Transfers to a Trust 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

Cessation of Donor’s Control 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) Transfer of assets into an irrevocable trust is a gift A trust is irrevocable when the grantor gives up all future control

Transfers Excluded from Gift Tax Transfer of marital property pursuant to a divorce A transfer to meet support obligations (as determined by state law) 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 Contributions to political organizations

Valuation of Gift Property 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 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

Annual Gift Exclusion 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) Future interests are not eligible Remainder interests Reversions

Gifts to Minors Section 2503(c) minor’s trusts qualify for annual gift tax exclusion if: Trustee may pay out income and/or trust assets before beneficiary reaches 21 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)

Gifts to Minors 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)

Gift Splitting 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

Gift Tax Deductions 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

Tax Consequences for Donees 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

Kiddie Tax Under the kiddie tax, unearned income (in excess of $1,600) of children under age 14 is taxed at their parents’ marginal tax rate

Education Savings Plans 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

Education Savings Plans 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) 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

The Estate Tax 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

The Taxable Estate Steps to compute the taxable estate Identify and value the assets included in the gross estate Identify the deductible claims against the gross estate and deductible expenses of estate administration Identify any deductible bequests The gross estate includes all property and property interests of the decedent

Probate 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 Gross estate includes property that transfers by will and by law

Living Trust 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

The Gross Estate 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

Life Insurance Proceeds 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) Insurance is included in the estate if it was transferred by gift within 3 years of death

Valuation Issues 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

Valuation Issues Market price method – used for stocks, bonds, and real estate Stocks valued at average of their high and low selling prices on valuation date Actuarial valuation used for annuities, life estates, terms certain and remainder interests Capitalization of earnings used when valuing businesses

Estate Deductions Any debts of the decedent and claims against property included in the gross estate Funeral expenses and administrative costs of settling the estate Casualty and theft losses incurred during the administration of the estate Bequests to charitable organizations Property transferred to surviving spouse Qualified terminal interest property (QTIP) trust allows the decedent to exclude value of property transferred in trust to spouse

GSTT 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 $1.5 million GSTT exemption is available to each grantor (2005)

Benefits of Planned Giving Transfer of investment property (bonds) allows a family to shift income to lower-bracket family members Offers few transfer tax benefits if there are small differences between current and future value Transfer of equity interest in flow-through entity offers both current income tax and future transfer tax benefits Buy-sell agreement Gift-leaseback arrangement

Advantages of Lifetime Gifts Shield post-gift appreciation from estate taxes (taxed on date of gift value) Take advantage of annual exclusion and gift-splitting Nontax advantages of trusts Protects property from creditors Shields assets from public scrutiny Allows ease of management for multiple beneficiaries

Disadvantages of Lifetime Gifts Carryover basis on gift property If donor had retained property until death, basis would have been stepped up to FMV 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

Fiduciary Income Tax Issues 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

Fiduciary Income Tax Issues 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

Basis Issues 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

Income Taxation of Trusts and Estates 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

Fiduciary Income Tax 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

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

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)

Gift Tax Return Form 709 gift tax return must be filed if there were any of the following transfers Transfers of present interests in excess of the annual exclusion ($11,000) Transfers of future interests Transfers to charitable organizations in excess of annual exclusion Transfers with gift splitting elected

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

Computing Estate Tax Gross estate tax Less: Gift tax on prior gifts Less: Unified credit Less: Other allowable credits Equals: Net estate tax liability Estate tax return, Form 706, due 9 months after death (6 month extension possible)

Kiddie Tax 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

Computing the Kiddie Tax Determine the child’s taxable income Calculate the tax on the child’s net unearned income in excess of $1,600 at the parents’ marginal tax rate The child’s remaining taxable income is taxed at the child’s normal tax rates The taxes determine in (2) and (3) are summed to determine the child’s gross income tax liability

Fiduciary Income Taxation 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

Types of Trusts 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

DNI 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

Fiduciary Filing Requirements 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

Distributions to Beneficiaries 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)

Distributions to Beneficiaries 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

The End