1. Chapter 12
Wealth Transfer Taxes

2. 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Estate tax will be repealed in 2010, but gift tax will be retained (sunset provisions automatically reinstate prior law in 2011)

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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)

16. 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)

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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)

33. 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

34. 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

35. 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 and $3.5 million in 2009 while lifetime gift exemption remains at $1 million

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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)

43. 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

44. 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

45. 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)

46. 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

47. 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

48. 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

49. 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

50. 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

51. 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

52. 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)

53. 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

54. The End