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12 - 1©2005 Prentice Hall, Inc.
Wealth Transfer Taxes
Chapter 12
12 - 2©2005 Prentice Hall, Inc.
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In 2001, Congress voted to reduce top rates gradually until they reach 45% in 2007Estate tax will be repealed in 2010, but gift tax
will be retained (sunset provisions automatically reinstate prior law in 2011)
12 - 3©2005 Prentice Hall, Inc.
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 lifetimeGifts given in later years are taxed at higher
marginal tax ratesTotal taxable gifts cause the decedent’s estate
to be taxed at higher marginal tax rates
12 - 4©2005 Prentice Hall, Inc.
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 2004 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
12 - 5©2005 Prentice Hall, Inc.
Transfers Subject to the Gift Tax
Gifts made directly or in trust and include gifts of all types of property whether real, personal, tangible, or intangibleServices 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
12 - 6©2005 Prentice Hall, Inc.
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
12 - 7©2005 Prentice Hall, Inc.
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 gift occurs at that time 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 propertyGift = value of other person’s interest
12 - 8©2005 Prentice Hall, Inc.
Life Insurance Transfers
Naming someone as beneficiary of a life insurance policy is not a gift
When all rights of ownership (right to borrow against policy, cash in for cash surrender value, and change the beneficiary) are assigned to another, a gift equal to the cost of a comparable policy is madePaying the premium on a policy owned by
another is a gift
12 - 9©2005 Prentice Hall, Inc.
Transfers to a Trust
A trust is a legal arrangement involving three parties 1. Grantor – the one who transfers assets that
become the corpus or principal of the trust
2. Trustee – the one who holds legal title to the assets and makes investment decisions
3. Beneficiary – the one who receives the legal right to the beneficial enjoyment of income or corpus
12 - 10©2005 Prentice Hall, Inc.
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) accountGrantor-parent can be trustee and maintain
control over the property
12 - 11©2005 Prentice Hall, Inc.
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 giftA trust is irrevocable when the grantor gives
up all future control
12 - 12©2005 Prentice Hall, Inc.
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 expensesPayment must be made directly to the
educational institution (tuition is excluded, but payment for room, board and books is a gift) or the person providing medical care
Contributions to political organizations
12 - 13©2005 Prentice Hall, Inc.
Valuation of Gift Property
Gifts are taxed on FMV at the date of the gift FMV is 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 sellFMV 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
12 - 14©2005 Prentice Hall, Inc.
Annual Gift Exclusion
Annual gift tax exclusion ($11,000) only allowed for gifts of present interest
Present interest includesOutright transfersLife estates (right for life)Term certain interests (right for specific time)
Future interests are not eligibleRemainder interestsReversions
12 - 15©2005 Prentice Hall, Inc.
Gifts to Minors
Section 2503(c) minors trusts qualify for annual gift tax exclusion ifTrustee may pay out income and/or trust
assets before beneficiary reaches 21Remaining 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)
12 - 16©2005 Prentice Hall, Inc.
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 exclusionElection 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)
12 - 17©2005 Prentice Hall, Inc.
Gift Splitting
Allows spouses to combine their $11,000 exclusions so together they can together 22,000 per donee per year by treating each gift as if half made by each spouseRequires consent of both spousesApplies to all gifts made during that year (or
during time they are married)Requires filing a gift tax return
12 - 18©2005 Prentice Hall, Inc.
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
12 - 19©2005 Prentice Hall, Inc.
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 exclusionsLess: Charitable and marital deductions
Equals: Taxable gifts for current periodPlus: Taxable gifts in previous periods
Equals: Cumulative taxable gifts
12 - 20©2005 Prentice Hall, Inc.
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)
12 - 21©2005 Prentice Hall, Inc.
Gift Tax Return
Form 709 gift tax return must be filed if there were any of the following transfersTransfers of present interests in excess of the
annual exclusion ($11,000)Transfers of future interestsTransfers to charitable organizations in excess
of annual exclusionTransfers with gift splitting elected
12 - 22©2005 Prentice Hall, Inc.
Tax Consequences for Donees
Donor’s adjusted basis (and holding period) generally carries over to the doneeIf appreciated property, basis increased by
proportionate amount of gift tax paid on appreciation
If FMV is less that basis, lower FMV is used to determine loss on subsequent disposition
12 - 23©2005 Prentice Hall, Inc.
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 rateFirst $800 covered by standard deductionSecond $800 (and all earned income) taxed at
child’s tax rates
12 - 24©2005 Prentice Hall, Inc.
Education Savings Plans
Earnings are not currently taxed and is never subject to tax to the extent income is used for qualified education expenses
Section 529 qualified tuition planNo annual limit on contributionsCan change beneficiaryDonor can cash out account by paying income
tax + 10% penalty
12 - 25©2005 Prentice Hall, Inc.
Education Savings Plans
Coverdell education savings accountsAnnual 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
12 - 26©2005 Prentice Hall, Inc.
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
12 - 27©2005 Prentice Hall, Inc.
The Taxable Estate
Steps to compute the taxable estate1. Identify and value the assets included in
the gross estate
2. Identify the deductible claims against the gross estate and deductible expenses of estate administration
3. Identify any deductible bequests The gross estate includes all property and
property interests of the decedent
12 - 28©2005 Prentice Hall, Inc.
Probate
Probate – the process under state law by which a will is declared legally valid and decedent’s property is transferred to the beneficiariesProbate 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
12 - 29©2005 Prentice Hall, Inc.
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 deathThe will only needs to designate the treatment
of any asset not in the trustUnlike a will, a living trust is not a public
documentProperty in a living trust is must be included in
the gross estate
12 - 30©2005 Prentice Hall, Inc.
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 deathGifts 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
12 - 31©2005 Prentice Hall, Inc.
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
12 - 32©2005 Prentice Hall, Inc.
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 deathIf elected it applies to all assetsGross estate and estate tax must both be
reduced to use the alternate dateIf assets are sold prior to alternate date, they
are valued at date of sale
12 - 33©2005 Prentice Hall, Inc.
Valuation Issues
Market price method – used for stocks, bonds, and real estateStocks 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
12 - 34©2005 Prentice Hall, Inc.
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
12 - 35©2005 Prentice Hall, Inc.
Computing Estate Tax
Gross estate
Less: Deductible expenses, debts, taxes, losses
Less: Charitable deductionLess: Marital deduction
Equals: Taxable estatePlus: Adjusted taxable gifts - prior periods
Equals: Tax base
12 - 36©2005 Prentice Hall, Inc.
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)
12 - 37©2005 Prentice Hall, Inc.
GSTT
Generation skipping transfer tax applies a separate flat tax at the highest transfer tax rate (48%) when a transfer skips a generationA direct transfer from grandparent to
grandchild is a generation skip $1,500,000 GSTT exemption is allowed each
each grantor in 2004
12 - 38©2005 Prentice Hall, Inc.
Benefits of Planned Giving
Transfer of investment property (bonds) allows a family to shift income to lower-bracket family members but 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 benefitsBuy-sell agreementGift-leaseback arrangement
12 - 39©2005 Prentice Hall, Inc.
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 trustsProtects property from creditorsShields assets from public scrutinyAllows ease of management for multiple
beneficiaries
12 - 40©2005 Prentice Hall, Inc.
Disadvantages of Lifetime Gifts
Carryover basis on gift propertyIf 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
12 - 41©2005 Prentice Hall, Inc.
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 itExamples: unpaid salary, interest, dividends,
retirement plan incomeDecedent’s basis carries over and character of
income also carries over
12 - 42©2005 Prentice Hall, Inc.
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
12 - 43©2005 Prentice Hall, Inc.
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 spouseBasis increase cannot increase property to
more than FMV
12 - 44©2005 Prentice Hall, Inc.
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
12 - 45©2005 Prentice Hall, Inc.
Trusts
Grantor trust – grantor retains some incident of ownership (such as reversionary interest) and income is taxed to the grantor
Simple trust – must distribute all of its accounting income annually to its beneficiaries; cannot make charitable contributions
Complex trust – any trust that is not a simple trust (estates are considered complex trusts)
12 - 46©2005 Prentice Hall, Inc.
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 contributionsSimple trusts allowed $300 exemptionComplex trusts allowed $100 exemptionEstates allowed $600 exemption
12 - 47©2005 Prentice Hall, Inc.
DNI
Distributable net income (DNI) is the current increase in value available for distribution to income beneficiariesDNI determines the fiduciary’s maximum
distribution deductionDNI determines beneficiary’s maximum
taxable incomeCharacter is retained so beneficiaries do not
pay tax on tax-exempt income
12 - 48©2005 Prentice Hall, Inc.
Fiduciary Income Tax Rates
2004 Rates15% on $0 - $1,95025% on $1,951 - $4,60028% on $4,601 - $7,00033% on $7,001 - $9,55035% over $9,550
Because beneficiaries are usually in lower marginal tax brackets, distributing the income annually to beneficiaries usually results in lower taxes overall
12 - 49©2005 Prentice Hall, Inc.
Fiduciary Income Taxation
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
12 - 50©2005 Prentice Hall, Inc.
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 basisBeneficiaries use trust’s adjusted basisIf property satisfies a required income
distribution, distribution deduction limited to lesser of property’s basis or its FMV (beneficiaries still use basis)
12 - 51©2005 Prentice Hall, Inc.
Distributions to Beneficiaries
Trustee can elect to recognize gain on distribution of appreciated propertyBeneficiary’s basis is FMVIf trust has unused capital losses, it can net
these losses against any capital gains resulting from the election
12 - 52©2005 Prentice Hall, Inc.
The End