The Strategist
2nd Quarter 1996 - Volume 3 Issue 2
We recently received an inquiry from one of
our clients asking us to define a "net gift" and whether it is a more
efficient way to make a taxable gift.
First, some background on net gifts. A net
gift is a gift in which the donor makes a taxable gift to an individual (donee)
that requires the donee to pay any gift tax liability. This relieves the donor
from having to pay the gift tax. The big question is how is the gift tax
calculated?
Let's look at two different examples. Assume
father has made prior taxable gifts to the extent that he is now in the 55%
gift tax bracket. He has received a $155,000 windfall that he does not need. If
he makes a taxable gift of $100,000, the gift tax will be 55% on the $100,000
gift or $55,000. Therefore, son receives $100,000 and father pays $55,000 in
gift taxes for a total cost of $155,000 from father's point of view.
Instead, what if father decided to give
$155,000 in taxable gifts to his son but his son must pay the gift tax on this
gift? Normally, the gift tax would be $85,250, however, if the son must pay the
tax, then the gift is not $155,000, but on a tentative basis is only $69,750.
This is calculated by taking the amount of the gross gift ($155,000) and
subtracting what is normally the tentative gift tax of $85,250. Therefore, the
gift tax is only 55% of $69,750 or $38,362 and not $69,750. However, if the
gift tax is less than the $85,250, then the gift is higher than the original
$69,750 which would mean that the gift tax liability is higher than the
$38,362. Sounds confusing, but there is a simple way to calculate the proper
formula.
First, take what the tentative tax is based
on the donor's gift tax bracket. In this case, it is $85,250 on a $155,000
gift. This will be your numerator.
Next, take 1 + the tax rate and this will be
the denominator. We know that father's tax rate is 55%, therefore, the
denominator is 1 + .55 or 1.55. When we take the tentative tax of $85,250 and
divide that by 1.55, we come up with a $55,000 gift tax. This is subtracted
from the amount of the gift ($155,000) to come up with the net gift of
$100,000. This is the amount that the son (donee) will receive after paying the
gift tax.
To briefly review the net gift, the son
received $155,000 of which he had to pay $55,000 in gift tax to net $100,000. This
is the same tax that father paid on a $100,000 gift to his son. In both cases,
the total cost to net the son $100,000 is $155,000 ($55,000 gift tax + $100,000
net to son). Therefore, there is no economic advantage to an individual making
a net gift.
A very important point to make here is that
the donee must be obligated to pay the gift tax under the terms of the
gift and that this can not be a voluntary transaction. If it is a voluntary
transaction, then the entire amount of the transfer ($155,000 in this example)
is subject to gift tax that must be paid by the donor. This would be $85,250.
Although there is no economic reason for
making a net gift, there may be psychological reasons for making net gifts. An
example of this would be where a donor has what I call "tax phobia".
In other words, this person hates, in no uncertain terms, sending any
unnecessary tax money to the IRS. If the donee or the recipient of the gift
does not have such a phobia, the donor can make a net gift and the donee will
pay the gift tax liability. Remember, however, that from an economic point of
view, whether it is a net gift or a regular gift, the total cost is the same.
A charitable remainder trust is a trust in
which a donor gifts assets (generally appreciated property) to a charitable
trust that he or she establishes and retains an income interest for the
remainder of their lifetime. At the death of the grantor, the assets in the
trust go to the charity designated in the trust document. The donor that makes
the gift to the charitable trust receives a current income tax deduction equal
to the value of the gift less the actuarial present value of the income
interest he or she retains during their lifetime.
There are two different forms of charitable
remainder trusts -- an annuity trust and a unitrust.
A charitable remainder annuity trust, known
as a CRAT, allows the income recipient to receive a fixed percentage of the
original value of the gifted assets each year as income, or more simply, a fixed
dollar amount each year. If donor gives property worth $1,000,000 to a CRAT
and retained an 8% per year income interest, donor would receive $80,000 per
year for their lifetime. If the trust grew in value to $2,000,000, the donor
would still only receive $80,000 per year. On the other hand, if the trust
decreased in value to $500,000, the donor will still receive $80,000 per year.
It is possible to exhaust all assets in a charitable remainder trust.
The second form of charitable remainder
trust is known as a charitable remainder unitrust or CRUT. Under this scenario,
the donor retains an income interest that is equal to a fixed percentage of
the value of the trust assets as re-valued each and every year. If the same
donor described in the previous example created an 8% $1,000,000 CRUT, that
individual would receive 8% of the value of the trust each year. If the trust
value remained at $1,000,000 each year, the donor would receive $80,000 each
year. If the value of the trust grows to $2,000,000, the donor receives
$160,000. However, if the value of the trust decreases to $500,000, the donor
receives only $40,000 of income in that year. It is technically impossible to
totally deplete a CRUT since the donor can only receive a stated percentage of
the fair market value of the trust each year.
There are other differences between a CRAT
and a CRUT. Let's briefly review some of those. A donor that establishes a CRAT
cannot make any additions to this trust. However, a person that establishes a
CRUT can make additions to this trust.
If an individual establishes a CRAT, it is
possible for the IRS to disallow the tax deduction if the retained income
interest is too high. The reason that the income tax deduction could be
disallowed is that the IRS uses hypothetical interest rates and assumes that
every individual that establishes a CRAT could live to age 110. Based on the
IRS's hypothetical earnings rate, if there is a greater than 5% chance that the
trust principal could be exhausted before age 110, the IRS will disallow the
deduction. This is not true in the case of a CRUT since it is impossible to
totally deplete the assets of a CRUT by taking your income interest.
We are often asked what is the best type of
charitable remainder trust for me -- a CRAT or a CRUT? Unfortunately, there are
no simple answers but it is possible to determine what is best for you based on
your goals.
Generally, if you can afford a variable
income and have a long life expectancy, a CRUT is probably the best choice
since it is like investing in stocks.
However, if you want a fixed dollar amount
of income each year, the CRAT is probably best since it is like investing in
bonds.
Beginning with this issue, the last column
will be devoted to a quick tip on money or estate planning savings. Here is
this quarter's tip ---
Consider naming your children as
co-executors and/or co-trustees of your estate planning documents. This will
allow your children to receive the normal published fees for performing these
services. For example, if you have named a trust to receive all of your assets
at your death and you name your children as trustees of this trust, your
children will have the right to receive normally published trust company fees.
If the fees are reasonable, they can be deducted from the trust's tax return.
The fees paid to the children will have to be reported as income but the
children will only have to pay a 39.6% federal income tax and therefore, your
children will net 60.40% of the fees paid to them.
If you are in the top 55% estate tax bracket
(assets over $3,000,000), it is more tax and cash efficient to pay fees since
they are subject to only a 39.6% maximum federal income tax rate versus a
maximum estate tax rate of 55%. Therefore, a child that receives $100,000 in
fees would pay approximately $39,600 in federal income taxes leaving that child
with $60,400 versus leaving assets to that child, either now or in the future,
subject to a 55% estate tax. This would net only $45,000 to the child. The result
is an additional $15,400 to the child.
If you have a question about any estate
related topic, please call or write to us. If you have a topic you think would
be of interest to our readers, let us know.
The
Wealth Transfer Group, Inc. is not engaged in the practice of law or accounting
nor are any of its employees, representatives, or agents. Tax and legal advice
should be obtained from qualified personnel.
(c) 1996 The Wealth Transfer Group, Inc.
283 Cranes Roost Boulevard, Suite 145, Altamonte Springs, Florida, 32701 (407)
339-5787
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