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Paying Income Taxes Can Reduce Estate Taxes
1. If you would like
more information
on our services,
please contact:
David Heilich, CPA
Member in Charge
Family Wealth Planning
314.983.1273
dheilich@bswllc.com
John Dooling, JD
Director of Estate Planning
314.983.1226
jdooling@bswllc.com
Paying Income Taxes
Can Reduce Estate Taxes
When income tax brackets were higher (as much as 90%), and there was a greater spread between the
lowest and highest brackets, the emphasis was on shifting income to taxpayers with lower tax brackets.
With more compressed brackets, rules that prevent shifting income to children, and the very low threshold
for high taxes in trusts, this kind of income tax planning is hard to achieve.
So the emphasis has shifted to using income tax to reduce later estate tax. The estate tax is only an issue for
individuals who have more than $5,340,000 and couples who have more than $10,680,000. But when it is
assessed, the rate is 40%.
High net worth individuals, their children and any trusts which they have created are in high income tax
brackets. So most of the income in the family is taxed at the same rate.
So part of the planning is on shifting the income tax to the older generation, to reduce the estate, and allow
the younger generation to accumulate assets without the cost of income tax. Can this be accomplished
without making gifts? Yes, by using the income tax rules themselves to shift the tax burden.
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Bob wants to reduce his estate by making a $1,000,000 gift to a Minors’Account for his 3-year-old son,
Jim. Any unearned income of Jim is subject to the“kiddie tax,”income tax at the parents’rate. But Bob is
permitted to pay the tax as his own. In year one, if the account earns 5%, the income would be $50,000,
and at a 40% income tax rate, the tax is $20,000. If Bob pays the tax from his capital, his estate is $20,000
smaller, without a gift, and the account has $1,050,000. If the account pays the tax, it only has $1,030,000.
At the end of 10 years, with the same 5% earnings compounded, and the same 40% tax bracket, the account
would have almost $285,000 more by having Bob pay the tax. This is a tax free gift that reduces the estate
tax, and increases the amount which passes to Jim.
Assume that Bob really wants to shift value and reduce his estate. Bob could lend money, say $9,000,000
to the trust described in Example Two. The trust is required to pay interest, and Bob is required to receive
interest. But the tax law allows them to disregard the interest for tax purposes. If the loan is made in August
2014 for nine years, the interest rate required to be charged on an annual basis is 1.89%. Using the same
earnings and tax rate assumptions, the first year the trust earns $500,000. The trust pays $200,000 interest
and principal on the promissory note, and Bob uses the $200,000 to pay the tax attributable to the trust. At
the end of the nine years, after payment of the note in full, the trust has assets of over $4,502,000—all from
Bob’s estate but with only a $1,000,000 gift. The rest is just a result of income tax shifting.
There are other methods of increasing the leverage involved in these strategies, such as through the use of
business entities of sales of assets, which are beyond the scope of this summary, but we would be happy to
discuss your situation further.
Warning
These are just a few examples of techniques to shift income tax and reduce estate tax. It is focused on estate tax savings
and many other issues must be taken into account in appropriate estate planning. It is general advice in accordance with
tax laws in effect in 2014. It is not intended to be financial, tax or legal advice to any individual. Each financial situation
and family situation is different, and you should talk to an advisor before making decisions regarding your estate planning.
The Internal Revenue Code requires a certain in depth analysis of tax issues of a recommendation for a taxpayer to be able
to rely on that analysis; this summary does not meet the requirements of such an analysis.
Example One: The Kiddie Tax
Example Two: The Defective Trust
Example Three: The Loan to a Defective Trust
Bob does not want Jim to receive the gift outright at age 21, so he would rather use a trust. So Bob creates
a“defective trust”, for which he will pay the income tax. The tax rules create certain rights which if retained
by Bob will make the income of the trust taxable to him. Bob retains such a right and breaks the rule, so we
refer to the trust as“defective.” So Bob can make that same $1,000,000 gift to a defective trust for Jim, and
be required to pay the tax for the income of the trust. The trust accumulates income without tax, and Bob
further reduces his estate by paying the tax.