Wealth Transfer Taxes

1. Wealth Transfer Taxes Chapter 12

2. History • The estate tax (based on the value of property transferred at the owner’s death) has existed in the U.S. since 1916 • The gift tax (based on the value of property transferred during the owner’s lifetime) has existed since 1932 • In 1976, Congress enacted the unified transfer tax system with unified graduated tax rates, ranging from 18% to 55%

3. History • In 2001, Congress voted to reduce top rates gradually until they reached 45% in 2007 • Estate tax is scheduled to be repealed in 2010, but the gift tax will be retained • Unless Congress acts before then, sunset provisions automatically reinstate the prior law in 2011 because these tax cuts were not paid for by a permanent source of revenue beyond 2010

4. 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 decedent’s estate to be taxed at higher marginal tax rates

5. Major Exclusions • Annual gift tax exclusion is $13,000 per donee per year (was $12,000 in 2008) • If all gifts are less than exclusion, no gift tax return has to be filed • Unified credit – lifetime transfer tax exclusion • The 2009 unified credit for an estate is $1,455,800 which is equivalent to tax on $3.5 million (referred to as exemption equivalent) • For lifetime gifts, the exemption equivalent is $1 million

6. 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

7. 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

8. 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 person’s name to the title of real property • Gift = value of other person’s interest

9. 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

10. 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

11. 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

12. 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 gift • A trust is irrevocable when the grantor gives up all future control

13. 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

14. 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

15. Annual Gift Exclusion • Annual gift tax exclusion ($13,000) 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

16. Gifts to Minors • Section 2503(c) minor’s 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)

17. 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 $65,000 can be transferred at one time with no gift tax consequences (provision can be used only once every 5 years)

18. Gift Splitting • Allows spouses to combine their $13,000 exclusions; by doing so, they can exclude $26,000 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

19. 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

20. Tax Consequences for Donees • Donor’s 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

21. Kiddie Tax • Unearned income (in excess of $1,900) of children under age 19 (age 24 if a full-time student) is taxed at their parents’ marginal tax rate • Unearned income includes taxable interest, dividends, net capital gains, and income received from a trust • Earned income (wages, salaries, tips) and the first $1,900 of unearned income are subject to the child’s normal tax rates

22. 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

23. 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 child’s education

24. 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 • Anestateis 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

25. 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

26. Probate • Probate – the process under state law by which a will is declared legally valid and decedent’s property is transferred to the beneficiaries • Probate 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

27. 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 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

28. 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

29. 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

30. 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 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

31. 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

32. 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

33. GSTT • Generation skipping transfer tax applies a separate flat tax at the highest transfer tax rate (45%) when a transfer skips a generation • A direct transfer from grandparent to grandchild is a generation skip • $3.5 million GSTT exemption is available to each grantor (2009)

34. 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

35. 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

36. 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 equivalent is $3.5 million in 2009 while lifetime gift exemption equivalent remains at $1 million

37. 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 it • Examples: unpaid salary, interest, dividends, retirement plan income • Decedent’s basis carries over and character of income also carries over

38. 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

39. 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

40. 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

41. Fiduciary Income Tax Rates • 2009 Rates • 15% on $0 - $2,300 • 25% on $2,301 - $5,350 • 28% on $5,351 - $8,200 • 33% on $8,201 - $11,150 • 35% over $11,150 • Because beneficiaries are usually in lower marginal tax brackets, distributing the income annually to beneficiaries usually results in lower taxes overall

42. 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 exclusions Less: Charitable and marital deductions Equals: Taxable gifts for current period Plus: Taxable gifts in previous periods Equals: Cumulative taxable gifts

43. 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)

44. 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 ($13,000) • Transfers of future interests • Transfers to charitable organizations in excess of annual exclusion • Transfers with gift splitting elected

45. 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

46. 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)

47. Kiddie Tax • Under the kiddie tax, unearned income (in excess of $1,900) of children under age 19 (age 24 if full-time student) is taxed at their parents’ marginal tax rate • First $950 covered by minimum standard deduction allowed for dependents • Second $950 (and all earned income) taxed at child’s tax rates

48. Computing the Kiddie Tax • Determine the child’s taxable income • Calculate the tax on the child’s net unearned income in excess of $1,900 at the parents’ marginal tax rate • Unearned income includes taxable interest, dividends, net capital gains, and income received from a trust • The child’s remaining taxable income is taxed at the child’s normal tax rates • The taxes determined in (2) and (3) are summed to determine the child’s gross income tax liability

49. 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

50. 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