Chapter 25

Transfer Taxes and Wealth Planning

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Learning Objectives

1. Outline the structure of federal transfer taxes

2. Describe the operation of the federal estate tax

3. Summarize the operation of the federal gift tax

4. Explain principles of wealth planning

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Federal Transfer Taxes

Common Features:

Common tax rate schedule

Unified credit Prevents taxation of all but large cumulative transfer “Exemption equivalent” is taxable amount of credit

Unlimited charitable deduction

Unlimited marital deduction for transfers to a spouse

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Federal Estate Tax

Designed to tax the value of property owned or controlled by an individual at death

The Gross Estate has two components:

Probate – Process of paying the debts of the decedent, and transferring the ownership of any remaining property to the decedent’s heirs

Probate Estate – Property owned by a decedent (titled in the name of the decedent) at the time of the death

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Federal Estate Tax

The probate estate includes property owned and in possession of the decedent at the time of death

Gross estate consists of: The probate estate

plus Value of certain automatic property transfers that take effect

at death

Automatic transfers include joint ownership with right of survivorship.

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Federal Estate Tax

Automatic transfers included in the gross estate: Property owned by the decedent in joint tenancy with right of

survivorship (tenants in common are included in the probate estate)

Proceeds of life insurance paid due to the death of the decedent if either of two conditions is met:

Decedent “owned” the policy Decedent’s estate or executor is the beneficiary of the insurance

policy Transfers within three years of death

These transfers are “grossed up” for the amount of gift taxes paid (if any)

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Federal Estate Tax

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Federal Estate Tax

Valuation Property is included in the estate at its fair market value at the

date of the decedent’s death Fair market value is “the price at which such property would

change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both have reasonable knowledge of the relevant facts”

Executor can elect to value the estate on an alternate valuation date, six months after death, if it reduces the gross estate and estate tax

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Federal Estate Tax

Valuation of remainders and other temporal interests

Future interests are valued at present value, calculated by estimating the time until the present interest expires

Present value calculation uses the §7520 interest rate published by the treasury

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Federal Estate Tax

Taxable estate is the gross estate reduced by:

Administrative expenses, debts, losses, and state death taxes

Marital and charitable deductions

Computation of estate tax

Adjusted taxable gifts Are prior gifts (not already included in the gross estate) Objective is to allow estate tax base to reflect all transfers

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Federal Estate Tax

Unified credit Eliminates transfer taxes on a estates with minimal lifetime

and testamentary transfers

Measured by current tax on exemption equivalent

Amount of cumulative taxable transfers that can be made without exceeding the unified credit

Credit is applied after reducing the total tax on cumulative transfers for taxes payable on adjusted taxable gifts

A surviving spouse whose deceased spouse died without using their unified credit is entitled to the unused credit (a deceased spousal unused exclusion amount or DSUEA)

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Estate tax example

Ed died this year with a taxable estate of $10 million. In 2008 Ed made a $1 million gift that was offset by the unified credit. What is the amount of estate tax due on Ed’s estate?

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Federal Gift Tax

Levied on individual taxpayers for taxable gifts completed during a calendar year

Transfers subject to gift tax:

Imposed on intervivos gifts, lifetime transfers of property for less than adequate consideration

Imposed once a gift has been completed (occurs when donor relinquishes control of the property and donee accepts the gift)

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Federal Gift Tax

Gifts specifically excluded from the gift tax

Incomplete and revocable gifts

Payments for support obligations or debts

Contributions to political parties or candidates

Medical and educational expenses paid on behalf of an unrelated individual

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Federal Gift Tax

Annual exclusion

Most gifts are eligible for an annual exclusion of $14,000 (2013) per donee per year

Gifts of present interests qualify for the exclusion A present interest is a right to own and enjoy the property

currently

Certain gifts of future interests placed in trust for a minor can also qualify for the exclusion

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Federal Gift Tax

Calculating taxable gifts

Gift-Splitting election increases the likelihood that gift tax will be reduced:

Better use of the annual exclusions or unified credits Potential for lower tax rate on a portion of the gift

Spouse must be married at the time of the gift and not divorce or remarry during the year

Both spouses must consent to the election by filing a timely gift tax return

Annual election that applies to all completed gifts

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Federal Gift Tax

Deductions are limited to the value of the gift after the annual exclusion

Marital deduction Gifts to a spouse but not gifts of nondeductible terminable

interests An interest that terminates and transfers to another upon an event

or after a specified amount of time

Charitable deduction No percentage limitation but qualifies for an income tax

deduction No gift tax return necessary for gifts of entire interest

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Federal Gift Tax

Computation of the gift tax Prior taxable gifts + current taxable gifts

Tax on cumulative gifts Purpose is to increase the tax base and thereby increase the

marginal tax rate applying to current gifts

Subtract gift tax on prior taxable gifts prevent double taxation of prior taxable gifts Tax is calculated using current rate schedule

Unused unified credit (calculated using current rate schedule)

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Gift tax example

Brian made a $7 million taxable gift this year. Previously he had made a $1 million taxable gift that was offset by the unified credit. What amount of gift tax is due on Brian’s gift?

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Wealth Planning Concepts

The generation-skipping tax (GST)

Supplemental tax designed to prevent the avoidance of transfer taxes through transfers that skip a generation of recipients

Not widely applicable as it does not apply to transfers that qualify for an annual gift tax exclusion

Income tax considerations

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Wealth Planning Concepts

Transfer tax planning techniques

Serial gifts Strategy saves gift taxes by converting a potentially large

taxable transfer into multiple smaller transfers that qualify for the annual exclusion

Bypass provisions Reduces estate taxes by using the unified credit of the

deceased spouse, transferring some property to beneficiaries other than the surviving spouse

The Step-up in tax basis