Wealth Transfer Taxes

1
Wealth Transfer Taxes

• Chapter 12

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• Estate tax will be repealed in 2010, but gift tax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 decedents 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 forInsufficient 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
  persons name to the title of real property
• Gift value of other persons 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 Donors 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) minors 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

• Donors 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 childs 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 individuals death to
  own and manage the decedents 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 decedents 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 decedents
  property is transferred to the beneficiaries
• Probate estate includes only the property
  governed by the will (or the states 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
  individuals 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
• Decedents 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
  decedents 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
  2006-2008 and 3.5 million in 2009 while lifetime
  gift exemption remains at 1 million

36
Fiduciary Income Tax Issues

• The decedents 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
• Decedents 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

• 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

41
Computing Taxable Gifts

• Includible current gifts
• Plus Half of spouses gifts (if gift
  splitting)
• Less Half of taxpayers 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 periods
  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
  childs tax rates

47
Computing the Kiddie Tax

1. Determine the childs taxable income
2. Calculate the tax on the childs net unearned
   income in excess of 1,600 at the parents
   marginal tax rate
3. The childs remaining taxable income is taxed at
   the childs normal tax rates
4. The taxes determine in (2) and (3) are summed to
   determine the childs 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 fiduciarys maximum
  distribution deduction
• DNI determines beneficiarys 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 fiduciarys tax year that ends within the
  beneficiarys 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 trusts adjusted basis
• If property satisfies a required income
  distribution, distribution deduction limited to
  lesser of propertys basis or its FMV
  (beneficiaries still use basis)

53
Distributions to Beneficiaries

• Trustee can elect to recognize gain on
  distribution of appreciated property
• Beneficiarys 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