Estate Planning. Tax Question (2013 Exam AM session, Q2 Part C)

CFA Level III Portfolio Management
#1

Regarding Q2, Part C, two reasons why tax considerations favor Ruente making a current gift to his daughter rather than transferring wealth to her upon death, the two reasons listed as follows (from the answer key).

Reason 1: Because his dauther’s income tax rate is lower than Puente’s and their pre-tax return are assumed to be the same, the future after-tax value of any gifted amount will be greater tahn if this amount stayed in Puente’ s estate. (This one I got it).

Reason 2: Because gift taxes are paid from Puente’s estate, the size of his taxable estate is reduced. (I got it to this point, but not the follows). Because his daughter’s estate will not be taxed, this lowers the ultimate estate tax that will be paid. The present value of this tax benefit is equal to the gift tax rate, multiplied by the estate tax rate, multiplied by the size of the gift.

My question is that wouldn’t his daugher’s estate be taxed either this estate is given through gift or inheritance, why there is any tax saving other than reducing Puente’s taxable estate base?

#2

I need help with this one too…

#3

I understood it from the point of relative value of gift / bequest .

( 1 -t + tgxtc) < = = Donor is paying the tax increases numerator … So the relative value would be higher. Im not quite sure if i got it right though.

#4

It was given in the question that Daughter didnt have estate tax, because it was too low or something explicitly. Thats the one about second point.

If IT WAS NOT GIVEN, only income tax would have been the positive point.

#5

I don’t understand why does she doesn’t have to pay the estate tax have something to do with the second point…

I mean, either way, through gift or estate from her dad, she doesn’t pay that estate tax, so what’s the differences there?

And "If IT WAS NOT GIVEN, only income tax would have been the positive point. "

Do you mean that the daughter’s income tax plays the difference here?

Thanks!

#6

His daughter’s estate will not be taxed because its value will be below the minimum taxable threshold.

it says so in the assumptions made by the investment adviser.

now because a) donor pays the tax - the amount of estate transferred is lower.

b) the estate gets a break to the extent of tig * tie (the + factor bilal talks about above).

RVTaxableGift = (1+r(1-TiDaughter)^n(1-Tig + tig * tie) / (1+r(1-tipuentes))^n ( 1-Tie)

  1. tidaughter < tipuentes. so numerator grows more.

  2. get the benefit of tig * tie since donor pays the estate tax. so RVTaxable gift is much higher.

#7

Bilal, do you know how this formula is derived? This is actually what the answer key provides I think.

thanks!

#8

cpk123, could you elaborate on this a bit please? I don’t quite get it… thanks!!! (and what is RV, relative value)

RVTaxableGift = (1+r(1-TiDaughter)^n(1-Tig + tig * tie) / (1+r(1-tipuentes))^n ( 1-Tie)

#9

It’s derived from the book lol …

it’s originally RV = gift / bequest

inv ( 1 + r ( 1-tg ) ) ^ n ( 1- tg )

inv ( 1 + r ( 1-te ) ) ^ n ( 1- te )

If gift is tax free then ( 1- tg ) at the end is ( 1 - 0) = 1

if gift is taxable and recepient pay then the equation is as is

if donor is paying the tax there will be a tax benefit (cause he is paying something the rec should pay) so the ( 1- tg ) becomes ( 1 - tg + tgxte)

#10

TgTe +1-Tg

If I rewrite it like above

Now does the principal amount transferred amount increases (as the daughter has reduced cash outflows from the expenses met the transferor)

So the above increased base is now subject to reinvestment.

Is my interpreation correct?

#11

Can we use formula, ie. RV TaxableGift = (1+r(1-TiDaughter)^n(1-Tig + tig * tie) / (1+r(1-tipuentes))^n ( 1-Tie) to deal with this question?

#12

Can somebody please explain to me why his Daughter’s estate tax rate has any bearing on the answer? The answers are ripped directly from the Relative Value formula for Giftor Paying Estate Tax:

Two reasons why tax considerations favor Puente making a current gift to his daughter rather than transferring wealth to her through a bequest upon his death: • Because his daughter’s income tax rate is lower than Puente’s and their pre-tax returns are assumed to be the same, the future after-tax value of any gifted amount will be greater than if this amount stayed in Puente’s estate.

• Because gift taxes are paid from Puente’s estate, the size of his taxable estate is reduced. Because his daughter’s estate will not be taxed, this lowers the ultimate estate tax that will be paid. The present value of this tax benefit is equal to the gift tax rate, multiplied by the estate tax rate, multiplied by the size of the gift.

Wouldnt the “ultimate estate tax that will be paid” be lower REGARDLESS of the daughter’s financial situation? It is a nice tidbid, but she would get the (Tg*Te) benefit regardless in helping to determine the Relative Value. Is that sentence just fluff to secure more points?

#13

I was not sure about this one either. The first reason:

“Reason 1: Because his dauther’s income tax rate is lower than Puente’s and their pre-tax return are assumed to be the same, the future after-tax value of any gifted amount will be greater than if this amount stayed in Puente’ s estate.”

Does not this implicitly assume that their capital gains tax rate is the same? The exercise only mention that they her income tax rate is lower than Puente, but how should we know that this is not only for ordinary income but also for capital gains that will come from the gift?

#14

Anybody with update here and why should we assume that his daughter also has lower tax rate for capital gains?

#15

.

#16

Taxes may be my worst section. Really have to keep drilling into it in the next couple weeks.

#17

2013 AM is the only one I cannot find - can someone post a link to the 2013 AM paper

Thanks!