12 - 1 ©2005 prentice hall, inc. wealth transfer taxes chapter 12

12 - 1©2005 Prentice Hall, Inc.

Wealth Transfer Taxes

Chapter 12


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In 2001, Congress voted to reduce top rates gradually until they reach 45% in 2007Estate tax will be repealed in 2010, but gift tax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)


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


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


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


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


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


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


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


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


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


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


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


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


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)


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)


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


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


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


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 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


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


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


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


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


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 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


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


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


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


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 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


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


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


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


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)


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


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


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


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


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


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 spouseBasis 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


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)


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


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


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


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


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)


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


The End

12 - 1 ©2005 prentice hall, inc. wealth transfer taxes chapter 12

Documents

gift tax gifts

gift slide

gift tax return

estate tax

transfer tax features

prentice hall

gift equal

unified transfer tax