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Lesson 1: Introduction to Taxation and How to Research

Unified Credit Example

Let's look at a comprehensive example illustrating how the unified credit works with taxable gifts.

Example

Arthur is a wealthy man who would like to reduce his estate before he dies. He is aware of the rules regarding estate taxes and gift taxes and wants to make certain he transfers as much of his wealth to his family as possible while paying minimal tax. He is married, and the current fair market value (FMV) of his assets is $12,000,000. Where do we start?

Well, we know that, thanks to the estate tax deduction, the total he can get rid of tax-free is $5.6 million through regular transfers.

Some simple subtraction tells us that $12,000,000 - $5,600,000 = $6,400,000. So what do we do with the rest? The following might be good options.

Transfer to Spouse

Since Arthur is married, his spouse might own half of his property depending on how it's titled. But what if she doesn't? Arthur should consider transferring assets into his spouse's name. (Unless there's some reason he doesn't want to: Pending separation? Much younger spouse? Gold-digger issues? Too naïve and trusting?)

Besides putting his spouse's name on property titles, Arthur can also transfer money to his spouse. But how much? Remember that she's also allowed to transfer $5.6 million tax-free when she dies, so it would make sense to transfer up to that amount to her as long as Arthur trusts her. This means that of his $12 million estate, he can transfer $5.6 million of the remaining $6.4 million to his wife with no gift or estate tax implications.

Time for some more subtraction: $6,400,000 - $5,600,000 = $800,000. We've come a long way, but that's still quite a bit for Arthur to pay taxes on. Unless there's some other way to avoid them.

Gifting and Tuition Options

Let's look at Arthur's family members and their pending events.

Thanks to the annual exclusion, Arthur can gift $15,000 to each of his family members each year tax-free—and so can Arthur's wife, for a total of $30,000 to each family member per year, none of which would be taxable.

In addition, Arthur can make payments to cover medical expenses and educational expenses for his family, and as long as he pays the institution directly, those gifts wouldn't be taxable either. So Arthur should consider paying for his children's education and medical bills and the education and medical bills of his grandchildren or other family members. He could even pay for nonfamily members, too.

Let's assume that Arthur is maximizing his gifts and finds that he will still have a taxable estate. What do we do in this case?

Donations

As Warren Buffett and Bill Gates have realized, they would prefer to give their hard-earned income to organizations that reflect their personal beliefs rather than give it to the IRS. Arthur should consider a clause in his will that provides for charitable gifts to be made with the remainder of his wealth, thus eliminating taxation on his estate. In this way, Arthur has been able to maximize his family wealth and minimize taxation.

Remember that when Arthur passes away, the executor of the estate will assess the value of his assets and subtract any unified deduction that remains after deducting the taxable portion of gifts he gave throughout his life. It's that final amount upon which estate taxes would be imposed. These rates can reach 40% on an estate.

While wealth transfer is not part of this course, it's an important topic for all accountants to study because everyone has an estate, and each estate's structure can impact the individual income tax of its beneficiary. Also, clients will come to you for advice on whether to gift now or wait to pass along their assets at death.

Now that we have covered the different types of taxes, it's time to look at the research process and the end result: a memo to file and a letter to the client.

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