1. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 25 Transfer Taxes and Wealth Planning

2. 25-2 Learning Objectives 1. Outline the basic structure of federal transfer taxes 2. Describe the federal estate tax and the valuation of transfers, and compute taxable transfers at death and the federal estate tax 3. Summarize the operation of the federal gift tax and the calculation of the federal gift tax 4. Apply fundamental principles of wealth planning and explain how income and transfer taxation interact to affect wealth planning

3. 25-3 Federal Transfer Taxes Introduction Federal transfers taxes Estate tax Gift tax Generation Skipping Tax (GST) Definitions Intervivos transfers Testamentary transfers

4. 25-4 Federal Transfer Taxes Common Features Common tax rate schedule Applied to cumulative lifetime transfers Unified credit Prevent taxation of all but the largest cumulative transfers “Exemption equivalent” is taxable amount of credit Unlimited charitable deduction Marital deduction for transfers to a spouse

5. 25-5 Federal Estate Tax Designed to tax the value of property owned or controlled by an individual at death The Gross Estate 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

6. 25-6 Federal Estate Tax The probate estate includes: Property in possession and control of the decedent at the time of death including:  Cash  Stocks  Jewelry  Clothing Property owned by or titled in the name of the deceased at the time of death The probate estate does not include property transferred automatically at the time of death

7. 25-7 Federal Estate Tax Gross estate consists of: Fair market value of property possessed or owned by a decedent at death (the probate estate) plus Value of certain automatic property transfers that take effect at death The gross estate includes more property than the probate estate

8. 25-8 Federal Estate Tax Property interests dictate the type of testamentary transfer Tenants in common hold divided rights to property have the ability to transfer these rights during their life or upon death  Property held by tenants in common is transferred in probate Joint tenancy with right of survivorship transfers title automatically to the surviving tenant upon the joint tenant’s death  no probate necessary so this type of property is specifically included in the gross estate

9. 25-9 Federal Estate Tax Property specifically included in the gross estate: Property owned by the decedent in joint tenancy with right of survivorship 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)

10. 25-10 Federal Estate Tax Valuation Property is included in the estate at its fair market value at the date of the decedent’s death Fair market value is defined by the willing-buyer, willing-seller rule as –  “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” 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

11. 25-11 Federal Estate Tax Taxable estate Administrative expenses, debts, losses, and state death taxes Marital and charitable deductions Computation of estate tax Adjusted taxable gifts Are gifts other than gifts included in the gross estate Objective is to allow estate tax base to reflect all transfers

12. 25-12 Federal Estate Tax Under progressive tax rate schedule, this adjustment is designed to increase the marginal tax rate on the estate Are not subject to tax in the estate formula To prevent double taxation of prior taxable gifts, the tentative estate tax is reduced by a credit for the taxes that would have been payable on adjusted taxable gifts under the current tax rate schedule Lifetime gifts are not subject to double tax because the tax on cumulative transfers is reduced for taxes on adjusted taxable gifts

13. 25-13 Federal Estate Tax Unified credit Eliminates transfer taxes on a estates with minimal lifetime and testamentary transfers Objective is to prevent the application of transfer tax to taxpayers 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

14. 25-14 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)

15. 25-15 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

16. 25-16 Federal Gift Tax Valuation of gratuitous transfers Gifts are taxed at the fair market value of the donated property on the date the gift becomes complete Despite the valuation of a gift at fair market value, the donee generally takes a carryover basis for income tax purposes

17. 25-17 Federal Gift Tax Annual exclusion Most gifts are eligible for an annual exclusion of $13,000 (2011) 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

18. 25-18 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

19. 25-19 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

20. 25-20 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

21. 25-21 Federal Gift Tax Unified credit Gift tax formula requires donors to keep track of the portion of the unified credit they used to offset prior taxable gifts, in order to prevent multiple applications of the credit Gift tax on previous gifts are computed using the current tax rate schedule and ignoring the use of the unified credit A surviving spouse whose deceased spouse died without using their unified credit is entitled to the unused credit (a deceased spousal unused exclusion amount or DSUEA)

22. 25-22 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

23. 25-23 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 Bypass provisions Reduces estate taxes by using the unified credit of the deceased spouse, transferring some property to beneficiaries other than the surviving spouse

24. 25-24 Wealth Planning Concepts The Step-up in tax basis Testamentary transfers allow a step-up in tax basis to fair market value, thereby eliminating income tax on unrealized appreciation Lifetime gifts eliminate transfer taxes on post gift appreciation

25. 25-25 Wealth Planning Concepts Integrated wealth plans Primary nontax objective of wealth planning is to preserve value during the transfer of control of business assets Essential nontax element of any effective wealth plan is to identify a safe mechanism for supporting the older generation and maintaining a specific lifestyle Example – Bypass trust, life insurance trust