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Family Tax Planning
Solutions to Problem Materials DISCUSSION QUESTIONS
26-1 Under the assignment of income doctrine, income must be taxed to the individual or entity that performs the service to earn the income. Investment income must be taxed to the owner of the capital asset that generated the income. (See p. 26-3.) Income shifting only results in tax savings if the taxpayer to whom the income is shifted is subject to a lower marginal tax rate than the taxpayer from whom the income was shifted. This condition is present only in a tax system with a progressive rate structure. (See Example 1, p. 26-3, and 1.) The IRS would consider all relevant facts and circumstances including educational qualifications of the employee, prior employment experience, time spent on the job, and the nature of the work actually performed. (See Example 3 and p. 26-6.) If the employee is a shareholder, the excessive compensation would be deemed a dividend to him. If the employee himself is not a shareholder but is related to other shareholders, the excessive compensation could be recharacterized as a constructive dividend to the other shareholders, the amount of which was then gifted to the employee. (See p. 26-10.) The unrestricted transfer of an equity interest in a business gives the transferee the right to dispose of his newly acquired asset, regardless of the transferor's wishes. Such transfer of ownership also can result in a dilution of control of the business. (See p. 26-11.) To prevent the transferee-recipient of an equity interest in a family business from disposing of the interest against the wishes of the family, the transfer can be subject to the condition that the transferee can dispose of the interest only after he or she has offered to sell it back to the family at fair market value. (See p. 26-11.) Income earned by a regular corporation that is distributed as dividends to shareholders is subject to double taxation. (See Example 8, p. 26-9 and 11 and 61.) An S corporation may not issue preferred stock. As a result, any family member who owns shares of stock in the S corporation will be taxed on an amount of corporate income proportionate to his or her stock ownership, regardless of his or her marginal tax bracket. Preferred stock cannot be used to give a preferential claim on income to low-bracket family members. [See Example 9, p. 26-10, and 1366(a).] 26-2 26-3 26-4 26-5 26-6 26-7 26-8 26-1 26-2 Chapter 26 Family Tax Planning 26-9 A grantor trust may be used when an individual desires to make a legal transfer of the ownership of property without totally surrendering all aspects of control over the property (e.g., a revocable trust to avoid probate). The grantor trust form also is useful if the transferor wants to relinquish ownership of property for a limited period of time (e.g., a reversionary interest). (See p. 26-17.) A Crummey trust provides that the beneficiaries have a current, noncumulative right to withdraw amounts transferred into trust during the year. Usually, the withdrawal right is limited to the amount of the annual gift tax exclusion. While both a Crummey trust and a 2503 trust secure the annual exclusion for the donor, the Crummey trust form allows the trust to continue after the beneficiaries reach age 21. (See p. 26-15.) A reversionary trust is a grantor trust if the value of the reversion exceeds 5 percent of the value of the assets subject to the reversion when the trust is created. This means that the value of a remainder interest must not exceed 5 percent. Using a 5% interest rate, this means that the grantor must leave the property with the trust for more than 14 years (i.e., the factor for 14 years is 5.05% and the factor for 15 years is 4.81%). If an interest rate of 10% is used, the grantor must leave the property more than 32 years! Most grantors are unwilling to give up the property for such a long period of time that is necessary to shift the income using a reversionary trust. For many years, taxpayers utilized interest-free demand loans between family members to accomplish an income shift similar to that available through the use of a reversionary trust. In 1984, the Supreme Court, in Dickman v. Commissioner, 104 S.Ct. 1086, held that the foregone interest-element of an interest-free demand loan constituted a taxable gift. Subsequent to this decision, Congress statutorily provided that interest-free or below-market-rate-interest loans between family members would create a taxable gift to the extent of the foregone interest. (See Examples 14 and 15 and p. 26-26 and 673 and 7872.) Gifts of assets that are appreciating in value ensure that future appreciation will not be taxed as part of the donor's taxable estate. Similarly, the income generated by gifted assets will not be included in the donor's taxable estate. (For other reasons, see Examples 26 and 27 and pp. 26-20 and 26-21.) Elderly taxpayers may fear that the inter vivos transfer of their wealth may leave them without sufficient means by which to live. They may worry that the recipients of the gifts may abandon them in their old age. (See p. 26-21.) An asset freeze is an estate planning technique that stabilizes the value of a taxpayer's assets that he or she will continue to own while transferring future increases in wealth to family members. (See Example 28 and p. 26-22.) It is preferable to make a charitable contribution during life. The value of the contributed asset is removed from the donor's future taxable estate, and the donor receives an income tax deduction for the contribution. (See p. 26-30 and 170.) The unlimited marital deduction defers Federal transfer taxation of a married couple's wealth until the death of the second spouse. It also allows equalization of the size of the taxable estates of both spouses, which in turn allows full utilization of the progressive rate structure and the unified credit. (See p. 26-33.) Prior to the creation of portability of the unified credit, a taxable estate of zero "wasted" the tax shelter provided by the unified credit. Prior to portability, the optimal taxable estate should result in a Federal estate tax liability just equal to the amount of the credit available. A taxpayer who desires to leave his or her wealth to a surviving spouse so that the spouse may use and enjoy the wealth during his or her lifetime but also desires that the wealth be disposed of in a specific way after the death of the surviving spouse will want to make a bequest to the spouse of qualifying terminable interest property. The value of the property is deductible from the gross estate of the taxpayer and fully includible in the gross estate of the surviving spouse. 26-10 26-11 26-12 26-13 26-14 26-15 26-16 26-17 26-18 Solutions to Problem Materials 26-3 PROBLEMS
26-19 a. b. $7,085 [2011 MFJ rates on taxable income of $52,900 ($83,000 business income $18,500 exemptions $11,600 standard deduction)]. Father has taxable income of $34,900 ($83,000 business income $18,000 salaries $18,500 exemptions $11,600 standard deduction). Tax on $34,900 (MFJ) $4,385. Each child has taxable income of $200 ($6,000 salary $5,800 standard deduction $0 exemption). Tax on $200 (Single) $20 3 $60. Total family tax bill $4,385 $60 $4,445. (See Example 1 and p. 26-3.) 26-20 a. b. $27,357 (2011 single rates on taxable income of $120,500 ($130,000 $3,700 exemption $5,800 standard deduction). K has taxable income of $30,500 ($40,000 salary $3,700 exemption $5,800 standard deduction) Tax on $30,500 (Single) $3,725. Corporation has taxable income of $90,000 ($130,000 business income $40,000 salary). Corporate tax on $90,000 $18,850. Reduction in tax bill is $27,357 ($3,725 $18,850) $4,782. (See Example 8 and p. 26-9.) 26-21 Sole proprietorship income Individual tax liability, ignoring exemptions and standard deduction (2011 MFJ rates) Corporate income Less salary expense Corporate taxable income Corporate tax liability Salary income Plus dividend income Individual income Individual tax liability (2011 MFJ rates) (15% on dividends) Total tax under corporate option Corporate tax liability Individual tax liability Total tax liability under corporate option Total tax under sole proprietorship option Income tax cost of incorporation (See Example 8 and p. 26-9.) $ 400,000 $ 109,872 $ 400,000 (150,000) $ 250,000 $ 80,750 $ 150,000 50,000 $ 200,000 $ 37,570 80,750 37,570 $ 118,320 (109,872) $ 8,448 $ 26-4 Chapter 26 Family Tax Planning 26-22 2011 tax on $35,000 for single taxpayer 2011 tax on $6,000 for single taxpayer Total 2011 tax on $41,000 (MFJ) $ $ $ 4,875 600 5,475 5,300 [In this example, S and F should marry before December 31. (See Example 2 and pp. 26-4 and 26-5.)] 26-23 H's salary W's salary Combined income Standard deduction Exemptions Taxable income Tax on $251,000 (MFJ) Tax on $140,500 ($150,000 $3,700 exemption $5,800 standard deduction) (S) Tax on $110,500 ($120,000 $3,700 exemption $5,800 standard deduction) (S) Tax on both incomes taxed at single rates The marriage penalty is $60,285 $57,514 (See Example 2 and pp. 26-4 and 26-5.) 26-24 $12,000 (950) (950) $10,100 33 % $ 3,333 $14,500 (2,800) $11,700 (10,100) $ 1,600 10 % $ 160 Interest income (unearned) Standard deduction allowable against unearned income for 2011 "Base" amount for 2011 Net unearned income Parents' marginal rate Tax on net unearned income M's gross income Maximum standard deduction (earned income $2,500 $300) Taxable income Net unearned income Taxable income taxed at M's marginal rate Rate $ 150,000 120,000 $ 270,000 (11,600) (7,400) $ 251,000 $60,284.50 $ $ $ 32,957 24,557 57,514 2,771 M's total tax liability is $3,493 ($3,333 $160). [See Example 10, p. 26-12, and 1(g) and 63(c)(5).] Solutions to Problem Materials 26-5 26-25 Option 1: Gift of investment property to shift $3,000 investment income to daughter D Tax liability of D in 2011 (ignoring special dividend tax) on $7,000 investment income: $7,000$950 "base"$950 standard deduction $5,100 taxed at 40% $950 "base" taxed at 10% Option 2: Salary of $3,000 to daughter D Tax liability of D on $4,000 investment income and $3,000 salary: $4,000$1,900 threshold (2011) $2,100 taxed at parents' 40% Gross income Standard deduction (earned income $300) Taxable amount Net unearned income ($4,000 - threshold $1,900 in 2011) Taxable income at D's marginal rate D's tax on balance of taxable income D's total liability ($840 $160) Family savings ($2,135 - $1,000) Note that this ignores any employment taxes that might be saved. [See Example 10, p. 26-12, and 1(g) and 63(c)(5).] $2,040 95 $2,135 $ 840 $7,000 (3,300) $3,700 (2,100) $1,600 10% $ 160 $1,000 $1,135 26-26 a. $70,000 (35% interest $200,000 partnership income). [See Example 6, p. 26-8 and 704(e).] b. ($140,000 $30,000 allocation to F) 50% $55,000 [See Example 7, p. 26-8, and 704(e).] 26-27 26-28 $42,000 (60% $70,000) to G and $7,000 (10% $70,000) to each of the four grandchildren. [See Example 9, p. 26-10, and 1366(a).] a. Gross income per child Standard deduction against unearned income (2011) Taxable income per child Tax liability at 10% rate Tax liability of children Tax to Taxpayer B ($9,000 40%) Net tax savings ($3,600 $615) 11Note that the kiddie tax does not apply to any of the three children since they are not less than 19 years old and not full-time students less than 24 (i.e., 19, 20 and 21). (See p. 26-14.) b. In 2011 if B and his wife elect to split their gifts for the year, each will make a taxable gift of only $11,000 (one-half the $100,000 or $50,000 value of the land less three $13,000 (2011) annual gift tax exclusions for the three donee children for a total of $39,000). The unified credit will offset the gift tax liability on each gift. The land and all future appreciation in its value will be removed from B's estate. $3,000 (950) $2,050 $ 205 3 $ 615 $3,600 $2,985 (See p. 26-20 and 2513.) 26-6 Chapter 26 Family Tax Planning 26-29 This problems illustrates how transfers into trust may be beneficial. Grandchild A has taxable income of $2,500 ($12,000 trust distribution $3,700 exemption $5,800 standard deduction). Tax on $2,500 (2011 single rates) $250. If Z did not create the trust, he would have to earn $15,385 [$10,000/(1 .35)] of before-tax income to yield $10,000 of after-tax income with which to make the gift. (Z is in a 35 percent marginal tax bracket.) Therefore, the net tax savings equals $5,135 [Z's tax bill on the $15,385 income (35% $15,385 $5,385)] $250 (A's tax bill), or $5,135. After payment of the tax, the net amount left to A is $11,750 ($12,000 trust distribution $250 tax liability). (See Example 12 and p. 26-14.) 26-30 26-31 Because this is a reversionary trust, the income will be taxed to the grantor, G. (See Example 14 and p. 26-16.) Because G's reversion is worth less than 5 percent of the value of the transferred assets, the trust is not a grantor trust and the income will be taxed under the normal subchapter J rules. (See Example 15, p. 26-16, and 673.) All income is taxed to F's brother; this is not a grantor trust in this year. If a grantor of a trust gives a power to an trustee to distribute income within a class of beneficiaries and the trustee is independent, then the trust is not a grantor trust under Section 674(c). [See Example 19 and p. 26-18 and 674(c).] All income is taxed to the grantor, M, per 674(a). N, who has the power to determine which of M's three minor children will receive trust income for the year, is not adverse to M. N is a nonadverse party. (See Examples 17 and 18 and pp. 26-18 and 26-19.) $9,000 to B; $51,000 to GS, per 677(a)(3). Under 677, a grantor is treated as owner of any portion of a trust the income of which may be distributed to the grantor or spouse without the approval of any adverse party. This rule also applies if trust income may be used to pay premiums for insurance on the life of the grantor and spouse. Here $9,000 is used to pay the premium of a life insurance policy on Grantor B. This rule applies even though the trustee is independent. (See Example 21, p. 26-19.) a. $8,000 to T; $72,000 to trust beneficiaries. This is what is often called either a beneficiary controlled trust or a Section 678 trust. Under Section 678, a person, T, other than the grantor is treated as the owner, if he has the right vest trust corpus or income in himself. In this case, T has the right to appoint 10 percent to himself. Therefore, he is taxed on 10 percent of the income or $8,000 (10% $80,000). [See Example 22, p. 26-19, and 678(a).] Per 2041, 10 percent of the value of trust corpus as of the date of death is includible in T's gross estate because T had a "power of appointment" over 10 percent of the trust. $135,000 total transfers (9 $13,000 (2011) annual exclusion) $18,000. There would be no taxable gifts made by either D or D's spouse since each split transfer, $7,500 ($15,000/2) would be less than the annual exclusion. (See p. 26-20 and 2513.) Federal estate tax on $9 million taxable estate (2011 rates) Less unified credit Tax due $13,000 (2011) exclusion 10 donees Reduction in taxable estate Federal estate tax (2011 rates) on $7,700,000 taxable estate ($9,000,000 $1,300,000) Less unified credit (2011) Tax saved $455,000 ($1,400,000 $945,000) [See p. 26-20 and 2503(b).] $3,130,800 (1,730,800) $ 1,400,000 $ 130,000 10 years $1,300,000 26-32 26-33 26-34 26-35 b. 26-36 a. b. a. 26-37 b. $2,675,800 (1,730,800) $ 945,000 Solutions to Problem Materials 26-7 26-38 If W dies with an estate of $10,000,000, the estate will pay an estate tax of $3,500,000 ($10,000,000 35%), leaving the heirs $6,500,000. If she makes a gift, however, the gift tax paid is removed from her estate, never to be taxed! Therefore the heirs can get substantially more as computed below. (See Example 27 and p. 26-21.) x .35x x 35x 1.35x x .35x amount of the gift gift tax $10,000,000 $10,000,000 $7,407,408 $2,592,592 11- If W makes a gift of $7,407,408, she will pay a gift tax of $2,592,592, exhausting the $10,000,000. By giving, the heirs receive $7,407,408 rather than $6,500,000 or $907,408 more! Note that this savings results from the fact that the amount paid in gift tax is never subject to tax (.35 gift tax of $2,592,592 $907,408). If the gift tax had been subject to tax, the tax would have been the same as the estate tax as demonstrated below. (See Example 27 and p. 26-21.) Tax on gift of ($7,407,408 .35) Tax on gift tax (.35 $2,592,592) Total tax if tax on gift tax 1126-39 a. 11Federal estate tax on $10 million taxable estate (2011 rates) Less unified credit (2011) Tax due Tax on $1.5 million taxable estate Less unified credit ( 2010) Tax saved $1,750,000 11c. $2,592,592 907,408 $3,500,000 $3,480,800 (1,730,800) $1,750,000 $ 555,800 (1,730,800) $ 0 b. No. The Acme stock value of $650,000 is not in excess of 35 percent of the adjusted gross estate of $10 million. However, if the insurance proceeds were not in the estate, $650,000/$1.5 million 43%, and the stock would qualify. (See Example 40 and p. 26-32 and 303.) TAX RESEARCH PROBLEMS
Solutions to the Tax Research Problems (26-4026-41) are contained in the Instructor's Resource Guide and Test Bank for 2012. ...
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This note was uploaded on 02/05/2012 for the course ACCT 110 taught by Professor Smith during the Spring '11 term at Adrian College.
- Spring '11