Accounting 815

Taxation of Transfers and Fiduciaries

Week 4: A Confiscatory Tax Riddled with Loopholes

Outline (c) 1998 Robert H. Daniels

Third Week Summary

Discussion of special rules for fiduciary income tax: tax free income and costs of getting it; DNI; distributions "carrying" income; distributions in kind. Income in respect of a decedent, which is "property" as well as income.

1. Review: DNI as carrier of tax information

Alternative methods of implementing tax passthru

Partnership and S-Corps

No tax at entity level
Income of entity taxed to owners whether or not distributed
  K-1's transmit information, which owner melds with return
Character of income items flows thru
Losses also flow through, subject to various limitations
  basis, at-risk, passive activity
Need to adjust owner's basis to prevent double taxation
  when previously taxed income is distributed

Mutual Funds

No tax at entity level
Net income of entity must be distributed to owners annually
  Punitive penalty tax if not done
Losses carry forward only at entity level
Character of income blended into "dividends"
  Limited exceptions for LT gains, exempt interest, etc.
No basis adjustment: reinvestment buys fresh basis

The Trust and Estate method of pass-thru

Fiduciary Income and/or principal may be distributed

Distributions of *either* transmit DNI to the owners/benes

Owners/ Benes taxed to the extent of their taxable DNI

Tax at entity level, on "retained" taxable income

Trust not taxed to the extent taxable DNI was transmitted out

In effect, the emphasis of trust rules is on having the benes pay, in preference to having the trust pay

Taxable income of trust itself is a "residual"
  what's left after items going to bene ary subtracted

Losses carry forward only at entity level, except in last year

Character of income generally flows through: K-1 forms

No adjustment of bene's "basis" in the entity (ordinarily)

Modifying Rules

Specific bequests do not carry out DNI

"Tiering"

Rules for allocating DNI when some benes get mandatory distributions and some get optional distributions

DNI allocated 1st proportionately among mandatory income recipients. Then the excess DNI is allocated proportionately among the discretionary recipients:

Example of Tiering.

Trust must pay 50 to S and 25 to Br, may pay excess income to S and C, discretion to use principal

Y is 65, pays S 60, Br 25, C 10
  the 65 is 2/3 S and 1/3 BR Rest is principal

Y is 90, pays S 60, Br 25, C 10
  first, S 50 and BR 25. The other 15 is equal to S and C

In Kind Distributions

Note: C-Corps and S-Corps recognize gain on distributions; P'ships don't.

Trusts and estates don't recognize gain unless they elect to

If no recognition, basis carries over and DNI is transmitted to extent of basis distributed

2. Income Taxes and inherited retirement benefits

Not part of probateable estate: bene designation controls
Are part of taxable estate: property right to deferred income

Where to find the rules (they are well hidden!)

Prop. Regs. 1.401(a)(9)-1 (1987), as amended 12/30/97 by REG-209463-82 re living trusts


• Announcement 95-99 (exam guide for qualified plans) 1995-48 I.R.B. 10
  
• IRS Notice 88-38 1988-1 C.B. 524 (IRAs and 403(b)’s)
  
• rules summarized in Pub 590, IRA’s

Mechanics of retirement payouts: the 3 key questions

Has D attained mandatory starting date? 70 1/2

If yes, what mandatory payout formula has been selected: recalculation or nonrecalculation/"term certain"

Who is the beneficiary? None (estate), individual, spouse?

Has not attained 70 1/2

Pay by end of 5th following year

Or pay each year 1/bene’s life expectancy (term certain)
  1st payment must be by end of following year

Unless bene is spouse – not need start until orig owner age 70 ½

special rule if spouse dies in gap period: bene then treated as tho spouse

Spouse can rollover or treat as own  No one else can

Has attained 70 1/2

Distribute to benes "at least as rapidly" as had been to owner

Unless spouse bene can treat as her own, rollover, etc

If bene not spouse. freeze the life expectancy, and use term certain for bene

If no bene? Goes to estate

If no recalc, remainder of term certain

If recalc, life expectancy is 0, so pay out all by end of next year.

3. Overview of Taxation of Estates

This is not an income tax. It is an excise tax on the transfer of wealth

Justifications

It raises money

It’s very progressive: hits the rich

Great hereditary fortunes may be bad for democracy

The heirs didn't earn it and the owner can't carry it to heaven

? Or: it's payback time for part of what D got from society

Major defect: the weird rate structure

Rates were set in 1976: Appear fairly gradual

Bracket Amount	Marginal Rate for Bracket	Tax, after Credit on $625,000
the first 10K	18%	nothing
10-20 K	20%
20-40 K	22%
40-60 K	24%
60-80 K	26%
80-100 K	28%
100-150 K	30%
150 -250 K	32%
250 - 500 K	34%
500 -750 K	37%	0 to 46,250
750 K- 1.0 mm	39%	46,250 to 143,750
1.0 - 1.25 mm	41%	143,750 to 246,250
1.25 - 1.5 mm	43%	246,250 to 353,750
1.5 - 2.0 mm	45%	353,750 to 578,750
2.0 - 2.5 mm	49%	578,750 to 823,750
2.5 -3.0 mm	53%	823,750 to 1,088,750
3.0 mm +	55%	1,088,750 plus 55%
10.0 mm - ?	5% surtax

5% surtax to offset the under 55% on the first 3 mm:
  $1,290,800 vs. $1,650,000 is $359,200
  Equals 5% surtax from $10 mm to $17,184,000

Above this, a 5% surtax to offset the exemption equivalent credit
  In 1998 is $202,050, so continue 5% surtax on next $ 4,041,000

Reason for this rate structure

The way Congress gave inflation relief in 1981
not by raising the brackets, but by exempting a base amount
$225 K exempt in 1982, to $600K in 1987

1997 Tax Relief Act Raised it again, in same way:

Year	Credit Amount	Exemption Equivalent
1987-1997	192,800	$ 600,000
1998	202,050	$ 625,000
1999	211,300	$ 650,00
2000-2001	220,550	$ 675,000
2002-2003	229,800	$ 700,000
2004	287,300	$ 850,000
2005	326,300	$ 950,000
2006	344,800	$1,000,000.

Problem:

As soon as Tp becomes subject to tax the marginal rate is 37% (now)
  and 41% in 2006

There’s no bracket where Tps are willing to say “ heck, let’s pay the tax”
  (contrast 15%, and maybe even 28% income tax brackets)

Tax either doesn’t affect folks at all, or grabs nearly half
 

The Estate Tax is a Semi-Voluntary Tax

No estate, no tax.

 So don't work so hard or save so much

spend all you have, or give it away

Run for Congress, or build a bonfire

Give it to kids who don't deserve it: neither does the gov't

Give it to grandchildren: skip estate tax on kids

Estate tax unworkable without a gift tax

Deathbed gifts for all but the suddenly departed

The Three basic exceptions to transfer tax

 transfer tax in a nutshell:

Tax all transfers at net fair market value, except

No tax on transfers to spouse or charity

No tax on the first $10,000 gift per giver per recipient per year

No tax on each transferor’s exemption allowance (now $625,000)

Looking for loopholes: How to use these rules to reduce tax

use the exemption in both H and W estates

lifetime gifts

disguise a gift as payment of an obligation

Leverage gifts, esp. with Life Insurance

Charitable gifts

Valuation of fractional interests, in extent and over time

4. Estate Tax Procedure (Chap. 28)

return required

if "estate tax base" (estates and txbl gifts) over $625K
  (exemption allowance)

Executor is responsible

Personal liability:

Problem for non-probate transfers)

Sec. 2204 discharge of liability: expedited review for auditability

if no executor, anyone in possession of property

Return and Payment due 9 mos from date of death

extendible. but time value charges

Which heir/beneficiary pays

Tax allocation clauses in wills, and state law default provisions

Should be kept out of marital deduction
  First Nat'l Bank case: Para. 28,079
residue after estate taxes divided equally
  e.g. 2mm: 1/2 to Spoise
  Solve for x X is tax on (1mm plus 1/2 x)
was 2 paras of will: problem w/ use of forms -- malpractice?
  note the estate planning liability tail

5. The Gross Estate: Chapter 15

 Sec. 2033 Property Owned by D

But: General attitude of courts had limited it

Also, Tp’s tried to control while avoiding ownership

so there are a number of extending code sections
"all you own and much that you don't"

the removal of a cloud or contingency over ownership is a kind of "transfer"

Unified (semi-unified) Transfer Tax

given an estate tax, need a gift tax

"in contemplation of death" hopelessly subjective
if they aren't unified, plan under the more favorable

e.g. if gift more favorable, then who pays estate tax?

those w/o tax planning


those dying suddenly


those w/too little $ to give it away

Unification makes it a tax on cumulative transfers

mechanics:

add each years taxable transfers to prior
calculate total tax and subtract prior taxes paid

Provisions that implement the unification:

2001(b):  estate added to prior taxable gifts
  less "aggregate" tax on post-'76 gifts

2012:  gift tax Cr for estate tax (on gifts included in estate)

2055 and 2056 (charity and spouse) parallel 2522 and 2523

Why it's only "semi-unification"

$10 K per donor/donee/year: Sec. 2503(b)
2503(d) for education and medical
no estate tax equivalent

estate tax has administration, funeral expenses
  these are hardly "voluntary", tho

    Build Date 2/17/98