Client has two trusts (revocable and irrevocable) and is considering which portfolio to sell shares from with tax minimization in mind. All income/realized CG/ and estate tax is flat at 20%. - Revocable : cost basis increases to MV at time of death and all asset subject to estate tax. - Irrevocable : cost basis does not change and asset not subject to estate tax. Both trusts will have identical CG taxes, but different estate taxes. Why does the solution go with revocable trust? Since the irrevocable trust is not subject to estate taxes, would’t this minimize tax?
Irrevocable would pay more CG tax due to lower cost basis.
Not sure if both have the same tax.
Imagine original cost basis = $100, at death MV = $200, heirs sold at $300.
Revocable: Pay 20% * ($200 - $100) at death, pay 20% * ($300 - $200) when selling.
Irrevocable: Pay 20% ($300 - $100) when selling.
Don’t know why revocable is preferable.
Here’s what the solution says :
Current taxes on realized capital gains will be the same for either trust.
Assets in the irrevocable trust are not subject to estate tax.
Asset sin revocable trust are subject to estate taxes upon Becker’s death,at which time the cost basis will be increased to market value.
Thus, total taxes are minimized by selling from the revocable trust.
If irrevocable trust estate tax =0, does this mean the revocable trust gives a tax refund with the cost basis revalution? (highly highly doubtful)
Its is saying that you have a future tax liability in the revocable trust that is uncertain, your death. So the more assets you can move from the revocable trust it will lower your future tax liability which is (Market value of stock minus cost basis) * number of shares * tax rate. If you sell shares now, this will lower the number of shares and therefore your future tax liability.
Its is saying that you have a future tax liability in the revocable trust that is uncertain, your death. So the more assets you can move from the revocable trust it will lower your future tax liability which is (Market value of stock minus cost basis) * number of shares * tax rate. If you sell shares now, this will lower the number of shares and therefore your future tax liability.
This question bugged me initially, too - see if you can get with my logic:
- Total taxes for the revocable trust will be 20% of the $900,000 gain ($180,000). The remainder of the position stays in the revocable trust and is subject to estate taxes, but because of the step up in basis at Becker’s death, cost=market and no estate taxes are due.
- Total taxes for the irrevocable trust are double because it receives no favorable step up in basis when Becker dies. So, taxes are paid at 20% on the $900,000 gain we’re concerned with in Objective 1 ($180,000), and then again at 20% when the remaining $1 million position ($900,000 gain) is liquidated by his benfeciaries. Thus, TOTAL taxes are $360,000 in this instance.
Where I got hung up (and I’m guessing this is what tripped you up, too) is in focusing on minimizing CURRENT taxes. The focus on minimizing TOTAL taxes is what changes things.
Hope this helped.
^ Don’t follow. How is the $900K gain taxed twice in irrevocable trust?
If via capital gains, you have to sell first, to be taxed at all. And you can’t sell the same position twice.
first on the current capital gains at the time of transfer to the trust. (this piece is the same whether it is a revocable or an irrevocable trust)
and later on when there is estate tax applied.(and this is only for the irrevocable trust).
cpk, the OP clearly states that there is no estate tax for the irrevocable trust.
Cgottuso8190 is correct . In the irrevocable trust there are no estate taxes. Any amount left in the irrevocable ( i.e. Not sold ) would grow in a tax free manner and be passed to the beneficiary . If on the other hand you leave some amount unsold in the revocable trust it will grow but attract estate taxes on both the principal and the gains. So if you must sell , sell in the revocable trust which will minimize estate taxes. CG will be same whichever trust sells .
Thanks to @cgottuso8190 for pointing me here from a previous topic on this question. (http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91320825#comment-91515442)
I disagree with @cgottuso8190’s interpretation. Estate taxes would still be owed on the revocable trust regardless of previous CG taxes paid, because estate taxes are always paid on the full amount of the trust. The step-up in basis is simply a benefit to prevent double taxation after the estate is transferred.
@cgottuso8190’s second point is incorrect because he adds in the second 1MM in assets, which confuses the math.
As I said on the other topic, the confusion seems to be entirely due to a lack of explanation of what happens to the assets after they are sold. If you assume the assets remain in the estate (as I did), then it is definitely more tax-efficient to sell from the irrevocable trust. If the assets are removed from the estate (spent?) then it’s more efficient to sell from the revocable trust.
There is no indication in the question what happens to the assets after they are sold. To me, it seems most logical that they would remain in the estate and be invested in other assets - after all, this was a concentrated position and it makes sense to diversify. Regardless, it seems clear that there is insufficient information to interpret this question correctly, and it’s very unnerving that the CFA Institute would have such an issue on an actual exam question. I’ve noticed errors in their books, and even in mock exams, but I assumed they held their exams to a higher standard. Now I’m not so sure.
@pdsewell: you got me doubting my explanation above because you made a compelling argument and I had no answer for you, so I didn’t respond. I’m currently going over the 2011 exam as practice problems right now and I think I’ve got it. First, revisit my proposed explanation above.
You’re right that the revocable trust will be subject to estate taxes regardless of the favorable step-up in basis when Becker dies.
Try this:
-
If you sell from the irrevocable trust: you pay capital gains taxes on that $1.0 million sale, and then will pay capital gains taxes on the remaining $1.0 million whenever you sell it ($1.8 million gain taxed at 20%). When Becker dies, the revocable trust is still there and the step-up in basis brings the cost from $200k to $2 million, and estate taxes apply to the full $2.0 million (20% on $2.0 million). So in this scenario, you essentially wind up paying 20% tax on $3.8 million ($900k gain on sale from irrevocable + $900k gain from remaining assets in irrevocable + 2.0 million revocable), or 760,000 total.
-
If you sell from the revocable trust, you pay tax on the $1.0 million ($900k gain) now and then the step-up occurs at Beckers death and estate taxes apply to $1.0 million. The irrevocable trust sits there untouched by estate taxes but the gains will be taxed when realized ($1.8 million). This brings total taxes in this scenario to $740,000 ( 20%($900k gain + $1.0 million remaining in revocable + $1.8 million gains in irrevocable)).
This question has given me fits.
assume it is sold in revocable trust:
shouldn’t total tax be 904000 dollars? = 20% (820K(after tax proceed estate) +900K(capital gain) + 1 Mil (estate) + 1.8 (capital gain in irrevocalbe)
Isn’t that the estate tax is paid (if any) when the assets are transferred to both trusts?
Is it simple to think that: For revocable trust, the cost basis is market value when the asset is transferred while the cost basis of irrevocable trust remains at cost basis 100,000 for 1million shares of Buildco. Hence, the subsequent capital gain for sale of Buildco shares wil be lower in revocable trust and is preferred.
yup, you’re right - that makes things easier.
I can’t come up with a better explanation for this question, but that statement is not correct. The question clearly states the estate taxes are paid upon death, not contribution.
the way to think about it is in terms of tax savings.
If you sell now out of the revocable, you reduce the estate taxes when he dies
If you sell now out of the irrevocable, you don’t take advantage of the no estate tax when he dies.
Sell out of Revocable now: total taxes when he dies would be 380k
900k *.2 sold now
1M * .2 estate taxes
While the Irrevocable would have 360k in taxes
(2M - 200K) * .2
For a total of 740K tax liability
Other scenario:
Revocable
Estate taxes 2M*.2=400K
Irrevocable
Cap gains (2M-200k)*.2= 360K
For a total of 760K tax liability
Therefore, less overall taxes by selling the 1M now out of revocable
Hi All,
There is another thing I don’t get;
Assets in an Irrevocable Trust are not supposed to be… Irrevocable? The Settlor shouldn’t be able to sell them, he has relinquished ownership.
The Trustee is now in charge, following the distribution decided when Trust was set up by the Settlor.
I don’t get how one could just sell the assets.
but in your Sell out of Revocable now scenario, actually the cash from selling the shares in revocable trust is also subject to estate tax unless the question states that the cash is getting out of the trust after selling