tax 101: basics of transfer tax and income taxgst tax, cont. note: portability does not apply to the...
TRANSCRIPT
Anne Katsas, Esq.
Port Estate Planning, LLC
©Port Estate Planning, LLC, 2015. All Rights Reserved.
Tax 101:
Basics of Transfer Tax and Income Tax
Introduction
Charitable donors are often motivated, at least in
part, by tax considerations.
Donors often have a team of advisors in addition to
their planned-giving officer (attorney, CPA, financial
planner, etc.), but it is important for planned-giving
professionals to be familiar with the tax issues that
Donors are thinking about.
Introduction, Cont. In general, donors are probably thinking about two
broad categories of taxes:
Transfer taxes:
Estate tax
Gift tax
Generation-Skipping Transfer (“GST”) tax
Income tax (including capital gains tax).
Transfer Tax
Three different kinds of transfer tax:
Gift Tax: Potentially applies when someone transfers property during his or her lifetime.
Estate Tax: Potentially applies when someone transfers property at death.
GST Tax: Potentially applies to a lifetime gift or to a transfer at death, if property is transferred to someone two or more generations younger.
Gift Tax:
Potentially applies when someone gives gifts
during his or her lifetime.
Some important exceptions:
Annual exclusion ($14,000 per donee, per year;
married couples can give twice that).
Tuition payments.
Payment of medical expenses.
Gifts to charity.
Gift Tax, Cont.
Gifts that are not within the exceptions are called
“taxable” gifts.
Taxable gifts must be reported on a gift-tax return
(IRS Form 709).
Just because a gift is a “taxable” gift, however, doesn’t
necessarily mean that there will be gift tax to pay.
Gift Tax, Cont.
Lifetime exemption from gift/estate tax.
The current set of transfer-tax laws established a
baseline transfer-tax exemption of $5,000,000 in
2010.
This amount is indexed for inflation each year.
In 2015, the exemption amount is $5,430,000.
Gift Tax, Cont. If you give a “taxable” gift, you report the gift on a gift-
tax return (IRS Form 709.) The amount of the taxable gift will be subtracted from your lifetime exemption.
Example:
Mother gives a cash gift of $200,000 to Daughter to help Daughter buy a house.
$14,000 of that can be considered an annual-exclusion gift. The remaining $186,000 is a taxable gift.
Mother’s lifetime exemption will be reduced by the amount of the taxable gift. After the gift, mother’s remaining exemption from gift/estate tax will be $5,430,000 - $186,000 = $5,244,000.
Gift Tax, Cont.
So, under current law, federal gift tax is only applicable
to very wealthy individuals.
Gift tax used to be a much bigger issue in estate
planning – the lifetime gift tax exemption was capped
at $1,000,000 for quite a while.
There are proposals in Congress to bring the gift-tax
exemption back to $1,000,000, even if the estate-tax
exemption remains higher.
If gift tax applies, the rate is 40%.
Estate Tax
Two different considerations:
Federal estate tax.
State estate tax (in some, but not all, states).
Federal Estate Tax Potentially applies at someone’s death, if the decedent’s
assets exceeded a certain threshold.
The threshold is basically the lifetime exemption amount ($5,430,000), reduced by the amount of any taxable gifts made during lifetime.
If total assets are below the threshold, no estate tax return needs to be filed, and there is no federal estate tax due; if the assets are above the threshold, an estate tax return (IRS Form 706) needs to be filed, and an estate tax might be due.
Federal Estate Tax, Cont.
Possible exception to the “threshold” calculation:
Portability.
Portability, new to the tax law in 2011 (and a
permanent part of the tax law as of 2013), allows a
surviving spouse to use the unused exemption of a
deceased spouse.
Federal Estate Tax, Cont.
Simple portability example:
Husband and Wife have combined assets of $8,000,000.
Husband dies. He had a very simple estate plan in which
he left everything outright to Wife.
If no portability election is made, at Wife’s later death, she will
only have her own exemption to use ($5,430,000). Any assets
above that amount will be subject to estate tax at 40%.
If a portability election is made, at Wife’s later death, she will
have her late husband’s $5,430,000 exemption to use, as well as
her own exemption; so if the assets are still $8,000,000, there
will be no estate tax due
Federal Estate Tax, Cont.
Some cautions regarding portability:
Has to be affirmatively elected by the executor of the
deceased spouse – is not an automatic entitlement.
(Election made by timely filing a federal estate tax
return.)
Some complex nuances – e.g. in the case of remarriages.
Applies only to federal estate tax – generally not to state
estate tax.
Does not apply to GST tax.
Federal Estate Tax, Cont.
Just because you have a “taxable” estate, does not
necessarily mean that you will have to pay estate tax.
Deductions reduce the amount on which tax needs to be
paid.
Examples of common deductions:
Marital deduction (if assets go to a surviving spouse, or to a
qualified trust for a surviving spouse).
Charitable deduction (if assets go to charity).
Administrative expenses.
State estate taxes.
Federal Estate Tax, Cont.
Federal estate tax is an issue for very few people
right now.
Very few individuals have more than
$5,430,000.
Very few married couples have more than
$10,860,000.
These amounts will be indexed for inflation.
High exemptions can make it harder to convince
donors to make large charitable gifts at death.
State Estate Tax
Although federal estate tax is not an issue for most people, for people in some states, state estate tax is an issue.
15 states currently have a state estate tax (including all the New England states except New Hampshire; New York; and New Jersey).
Some states impose “inheritance” taxes instead of (or in addition to) a state estate tax.
Payable by the recipient of inherited property, rather than by the estate of the decedent.
State Estate Tax, Cont.
State estate taxes are generally marginal-rate systems, not flat-rate systems.
If you owe estate tax, you generally owe tax on all your assets, with the assets taxed at applicable marginal rates (with adjustments in some states to prevent a “cliff ” situation – e.g. in Massachusetts, you’re not worse off if you die with $1,000,001 than if you die with $999,999).
State Estate Tax, Cont.
Thresholds range from state to state:
Low of $675,000 (New Jersey).
High of an amount equal to the federal
exemption (Delaware, Hawaii).
Massachusetts has one of the lowest amounts
($1,000,000).
State Estate Tax, Cont.
The threshold amounts are very much a moving target;
there is legislation in several states that will increase
the state threshold over a period of several years.
e.g. New York and Maryland, which will increase
over the next few years to eventually reach the
federal exempt amount.
e.g. Rhode Island and Minnesota, which will increase
over the next few years to reach an amount less than
the federal exempt amount.
State Estate Tax, Cont.
Lots of flux in the state estate tax arena.
Quite possible that some states might drop state estate
tax altogether in the future, or increase threshold
amounts (perhaps dramatically).
So, the need to plan for state estate tax might, in general,
wane over time, even in states where it is currently still
an issue.
State Estate Tax, Cont.
State estate tax rates are marginal.
Most states’ rates top out at 16%.
In Massachusetts, top marginal rate applies to asset
levels over $10,040,000.
A couple of states (Maine, Connecticut) currently
top out at 12%.
Washington state tops out at 20%.
GST Tax
Is a tax that potentially applies when transfers are
made to grandchildren (or more remote
descendants), or to other individuals who are
considered to be more than one generation
younger than a donor.
GST Tax, Cont.
Why is there a GST tax?
Example: Grandmother has used all her exemption
from gift and estate tax. Any transfers she makes from
now on will be subject to transfer tax.
Assume Daughter (Grandmother’s child) is also wealthy
and has also used all her gift and estate-tax exemption.
If Grandmother gave Daughter a $1,000,000 gift,
Grandmother would owe $400,000 in gift tax. If
Daughter later gave her child, Grandchild, a $1,000,000
gift, Daughter would owe $400,000 in gift tax.
GST Tax, Cont.
To get $1,000,000 from Grandmother to Grandchild,
the Treasury has collected $800,000 in transfer tax.
What if Grandmother gave $1,000,000 directly to
Grandchild, bypassing Daughter? Absent a GST tax,
there would be only the $400,000 of gift tax to pay; the
government would be been “cheated” out of one layer of
transfer tax.
The GST tax aims to plug this “loophole,” imposing an
extra transfer tax when gifts (either during lifetime or at
death) skip over a generation.
GST Tax, Cont.
Some exceptions from GST tax:
Annual exclusion
Most (but not all!) of the time, if a gift qualifies
for the $14,000 gift tax annual exclusion, it will
also qualify for the GST tax annual exclusion.
Medical and tuition payments that qualify for gift-
tax exclusion also qualify for GST tax exclusion.
GST Tax, Cont.
There is a $5,430,000 per person lifetime exemption
from GST tax, that applies to “GST-taxable” transfers.
If you make a GST-taxable gift, you need to “allocate”
GST exemption to the gift in order to keep the
transfer free of GST tax. The exemption allocated will
reduce the amount of lifetime GST exemption that
you have left.
GST Tax, Cont.
Note: Portability does not apply to the GST tax. If a
married couple anticipates needing to use more than
$5,430,000 of GST exemption, they will need to do
some traditional estate planning (involving trusts) at the
first death.
GST Tax, Cont. There are lots of technical rules associated with GST tax.
Rules regarding allocation of GST exemption to trusts.
Rules regarding treatment of trusts that were created before the GST tax came into being, and that are thus “grandfathered” for GST purposes.
Rules regarding whether and when you can allocate GST exemption to certain kinds of trusts.
Planned giving arrangements sometimes are not the best vehicles for transferring assets to grandchildren.
Important that an estate planning attorney and a CPA be involved in decisions about giving that involve GST issues.
Income Tax
The current estate tax landscape:
Federal estate tax applies to less than 1% of the population.
More than half the states in the U.S. have no state estate tax.
Of the states that have a state estate tax, rates are relatively
modest.
The current income tax landscape:
Income taxes for high-earning individuals are high.
Income taxes for ANY trusts (even non-high-earning
trusts) are high. (Trusts reach highest marginal rates at
income of just $12,300.)
Income Tax, Cont.
The basic takeaway: Income tax planning (including capital-gains tax planning) is becoming an increasingly important part of trust and estate planning.
Sometimes, planning that is good from an estate-tax perspective isn’t so good from an income-tax perspective (and vice-versa).
It used to be that estate planners didn’t worry too much about income taxes, because estate taxes were consistently higher than income taxes. That is often not the case anymore.
Income Tax, Cont.
Income tax is a tax paid on “taxable income.”
Taxable income is, very generally, gross income minus
allowable deductions.
Income Tax, Cont.
Gross income includes:
Wages, salaries, tips, etc.
Interest income.
Dividends and capital gains.
Distributions from retirement plans.
Rental income.
(Not a complete list)
Income Tax, Cont. Deductions can include:
Charitable contributions
Medical expenses (if they are high enough relative to your income)
Mortgage interest
State and local taxes
(Not a complete list)
Partial (limited) phase-out of deductions for high-income people.
If you are subject to AMT, your allowable deductions will change.
Income Tax, Cont.
Different types of income are taxed at different rates.
For “ordinary income”, there are currently seven marginal rates:
10%
15%
25%
28%
33%
35%
39.6%
Income Tax, Cont.
Note that these are marginal rates, not overall rates.
So, your first tranche of income is taxed at the lowest
rate; your next tranche at a higher rate; and so on, until
you have paid tax on your last dollar at your highest
marginal rate.
When people talk about being “pushed into a higher tax
bracket,” that doesn’t mean that all of their income is
going to be taxed at the higher rate; it’s just the amounts
that are above the threshold for the higher rate, that are
going to be taxed at the higher rate.
Income Tax, Cont.
There is a vast difference between how the ordinary-income rate tables apply to individuals vs. how they apply to estates and trusts.
Single people don’t hit the 39.6% bracket until they have taxable income of $400,000, and married couples (filing jointly) when they have taxable income of $450,000.
Trusts and estates, by contrast, hit the highest marginal rate at income of $12,300.
Income Tax, Cont.
“Qualified dividends” and long-term capital gains are taxed at different rates than ordinary income.
Qualified dividends – generally dividends from domestic corporations, and certain qualified foreign corporations, that have been held for a certain amount of time.
Capital gains – generally, the difference between what you paid for an asset, and what you sold it for.
Income Tax, Cont.
Tax rates for qualified dividends and capital gains:
0%
15%
20%
Income Tax, Cont. Net Investment Income Tax (“NIIT”): A (relatively) new
tax of 3.8%.
If your modified adjusted gross income is over a certain threshold ($200,000 for singles, $250,000 for married filing jointly), you are potentially subject to the tax.
If you are subject to the tax, the 3.8% tax will be applied to the lesser of (1) the amount by which your MAGI exceeds the threshold and (2) your “net investment income.”
Note: Distributions from retirement plans are excluded from the definition of NII.
Income Tax, Cont.
Important income-tax concept for estate-planning
purposes: Basis step-up.
“Basis” (also known as cost basis, or tax basis) is basically
the amount that you paid for an asset.
With some adjustments: For example, in the case of
real estate, the value of capital improvements can be
added to your basis.
Income Tax, Cont.
If an asset is includable in your taxable estate at your death (say, because you owned it outright, or in a revocable trust), then upon your death, the basis of that asset is re-set to the value of the asset as of your date of death.
As of your date of death, the capital gains tax on highly appreciated assets just disappears!
For many taxpayers (especially high-income ones), eliminating the capital-gains liability is a huge benefit.
Income Tax, Cont.
Sometimes planning that is good from an estate-tax
perspective isn’t so good from a capital-gains tax
perspective (e.g. if you set up a trust for a child
during your lifetime, appreciation on the trust assets
will escape estate tax at your death; however, the
assets will not get a step-up in basis at your death).
Planning for state estate tax vs. planning for capital
gains tax is a huge issue for estate planners right now.
Income Tax, Cont. Is basis step-up, combined with high estate tax
exemptions, going to pose a challenge for charities? Low-basis assets used to be a very attractive gift for
charitable organizations. People could reduce their taxable estates (by getting rid of the appreciated asset), and also eliminate capital gains tax on the asset.
But now, many people don’t need to reduce their taxable estates – they have more than enough exemption available to cover all their assets, so they won’t owe any estate tax. Might these people be inclined to keep their low-basis assets, to get the step-up at their death, and then pass the assets to children?
Income Tax, Cont.
One thing to watch for in the next few years: What will happen to “stretch” IRAs?
The common wisdom is that IRAs are great gifts to give to charities. If an individual makes a withdrawal from an IRA (non-
Roth), the withdrawn amount is taxable ordinary income to the individual.
By contrast, if a charity makes a withdrawal from an IRA, there is no income tax obligation, since the charity is not subject to income tax.
Income Tax, Cont.
Lately, though, charities have been getting some competition from “stretch” IRAs.
If you name an individual, or a qualifying trust for an individual, as your IRA beneficiary, the beneficiary can “stretch out” required minimum distributions from the account over his or her life expectancy.
This can be a very powerful tool for young (or even relatively young) beneficiaries -- may years (or decades) of tax-deferred growth.
Income Tax, Cont. There is a movement afoot in Congress, however, to
require all non-spouse beneficiaries of IRAs to withdraw the inherited account within five years.
This, of course, would greatly accelerate the income tax on the account.
If this happens, you might see renewed interest in making charities IRA beneficiaries. And perhaps more people looking to planned-giving vehicles
(e.g. CRTs) as IRA alternatives? (i.e. a way to give a beneficiary a steady stream of income over his or her lifetime).
Disclaimer This presentation is for general educational and informational
purposes only. It is not formal legal advice, and it does not offer any advice or opinions regarding your own (or your own clients’) particular circumstances or any other specific situation. Attendance at this presentation and/or receipt of this material does not establish an attorney/client relationship between you and Port Estate Planning, LLC; you are not a client of Port Estate Planning, LLC unless and until an engagement letter establishing you as a client has been signed by both you and by Anne Katsas. You are urged to consult with an attorney of your choosing regarding your specific circumstances. Any attorney attending or reviewing this presentation is responsible for coming to his or her own professional opinions and conclusions regarding the matters discussed herein.
Contact Information
Anne Katsas, Esq.
Port Estate Planning, LLC
6 Harris Street
Newburyport, MA 01950
978-518-9543
www.portestateplanning.com