Managing and shifting wealth

An estate refers to all the property a person owns or controls. The property in one's estate may consist of financial assets (bank accounts, stocks, bonds, or business interests), tangible personal assets (artwork, collectibles, or vehicles), immovable property (residential real estate or timber rights), and potentially intellectual property (royalties).

Estate Planning refers to the process of preparing for the disposition of one's estate upon death and/or during one's lifetime.

Estate Planning Goals

Maintaining Sufficient Income and Cash

Donors (those giving away wealth) need to plan not only for their own cash flow needs but also those of the done. This includes creating sufficient liquidity to take care of any gift and/or estate taxes that may arise.

Asset Control Issues

Donors may desire to pass on the benefits of an asset (income, price appreciation) but without necessarily giving the decision-making responsibilities along with those assets. This could be the case for an investment portfolio. Some donors are worried that a financially irresponsible heir could spend it all down. This is often the case for privately-held companies, in which the previous generation wants to transfer wealth tied up in the firm, but without giving voting stock to the next generation who may not be ready to handle the responsibilities of running the firm.

Asset Protection

Trusts and other legal entities can often be used to help shield certain assets from creditors. In some countries with forced heirship laws, these same entities can help shield the assets from being subject to the forced heirship laws. Forced heirship is a situation in which spouses and children are legally entitled to inherit part of an estate regardless of the wishes of the donor.

Asset Transfer (Inheritance)

Generally, assets may be passed on either via gifts (during life), or bequests (after death). Those with wealth to transfer may want to consider generation-skipping opportunities where available. As the name implies, this transfer to a grandchild saves the family a layer of inheritance tax, and can therefore be quite powerful.

Preserving Family Wealth

Family governance systems are sometimes set up to mitigate potential disputes and regulate the progression of the family goals into the future. These governance documents typically lay out the desired legal structure of the family including trusts, foundations, life insurance, various legal firms, etc.

Business Succession Planning

Founders (or current owners) can use estate and gift planning to transfer control and beneficial ownership of the family business to the next generation. Founders may also be faced with the choice of delegating managerial duties to outsiders, keeping the business within the family, or even selling it for cash.

Charitable Giving

Most jurisdictions provide gift tax or estate tax deductions or exemptions for charitable giving to qualified charities or private foundations, leaving more capital available to support charitable causes. Tax deductions may also be available for charitable donations made during the donor's lifetime. Private foundations can also serve as a long-lasting family legacy around which subsequent generations can gain an understanding of family values.

Estate Planning Vocabulary

A Will is a foundational estate planning document that outlines the rights that others will have over the property in an estate upon death.

Probate is the legal process that confirms the validity of a will so that all interested parties can rely upon its validity. Many individuals often wish to avoid probate, as it makes a public record of a family's financial affairs and can be costly in terms of hiring the necessary legal help, and paying the court fees.

In many cases, probate can be avoided by holding assets in other forms of ownership, such as:

• Joint ownership (e.g., joint tenancy with right of survivorship).
• Living trusts.
• Retirement plans.

Through these structures, ownership of property is transferred to beneficiaries without the need for a will and hence the probate process can be avoided or substantially reduced.

Intestate is a term used to describe anyone who has passed away without a valid will. In such a case, the local courts will decide upon the disposition of the deceased's assets.

Transfer Types

Tax-savvy donors and advisors must be aware of the various transfer methods that exist. These methods will be subject to different tax rules, and thus will produce different after-tax wealth amounts depending on the situation.

Lifetime Gratuitous Transfers, also known as inter-vivos transfers or gifts, are made without the intention of receiving anything in return. Many jurisdictions have both annual and lifetime limits on how much may be transferred until gift taxes are owed, while others may not allow any gifting at all without a gift tax being paid.

Testamentary Gratuitous Transfer is often also called an inheritance. Testamentary means that the transfer was laid out in the last will and testament of the decedent. Inheritance tax, as it is also known, may be applied to either the gift-giver, or the recipient, and can lead to large changes in the relative attractiveness of the option to use a bequest (transfer upon death), or a gift in order to transfer the asset (more about this in the next reading).

Progressive tax rate systems are those which include thresholds and increase the amount of inheritance tax due the larger the transfer grows. The first 100,000 may be subject to a low 2% rate, but the next 100,000 could be subject to a 4% rate. The total blended tax on the first 200,000 transferred would be 6,000.

Lifetime Gifts and Testamentary Bequests

Many jurisdictions allow the transfer of gifts up to certain limits, whether those are periodic or lifetime. For example, a country may permit up to a $15,000 annual gift with no taxes, or up to $250,000 lifetime. If either of these limits is breached a gift tax will be imposed.

Tax-free Gifts

The following model weighs two options that those who wish to transfer wealth have:

• Making a tax-free gift (one that falls under the exclusion amounts),
• Waiting until death and making a bequest.

$$ RV_{\text{Tax-free Gift}} = \frac { FV_{\text{Gift}} }{ FV_{\text{Bequest}} } $$

Where:

\(FV_{\text{Gift}} = [1+ r_g(1-t_{ig})]^n\)

\(FV_{\text{Bequest}} = [1 + r_e(1-t_{ie})]^n (1-t_e)\)

\(r_g\) = Pre-tax return to the gift recipient.

\(r_e\) = Pre-tax return to the estate.

\(t_{ig}\) = Effective tax rate on investment returns to the gift recipient.

\(t_{ie}\) = Effective tax rate on investment returns to the estate.

\(t_e\) = Estate tax rate.

\(n\) = Number of periods until gift maker's death.

The formula for the relative value of a tax-free gift shows the gift growing at the rate of return the recipient would earn before paying any taxes. The final portion of the term \((1-t_{ig})\) accounts for the taxes the recipient would pay for the gift growing in their account.

The future value of a bequest shows the bequest growing at the return the estate would earn, and then also being taxed at the estate's appropriate investment returns rate. The final portion of the term shows the estate tax due on the future amount.

The higher the quotient in this model, the more gifting is favored over a bequest. Any value over 1.0 indicates gifting is preferred.

If the pretax return and effective tax rates are equal for both the recipient and donor, the relative value of the tax-free gift simply reduces to \(\frac {1}{(1 − T_e)}\).

For example, consider the value of a €10,000 bequest in today's value subject to a 40 percent inheritance tax, netting €6,000 after tax. If the wealth is instead transferred as a tax-free gift without having to pay the 40 percent inheritance tax, the relative value of the tax-free gift is 1.67 times \(\left[i.e., \frac {1}{(1 − 0.40)} \right]\) as great as the taxable bequest, or €10,000 versus €6,000.

Taxable Gifts (Gift Tax Paid by Recipient)

When the exclusion amounts may not be met, and the recipient expects to pay a gift tax, the model changes slightly, as follows:

$$ RV_{\text{Taxable Gift}} =\frac {FV_{\text{Gift}} }{ FV_{\text{Bequest}} } $$

Where:

\(FV_{\text{Gift}} = [1+ r_g(1-t_{ig})]^n (1-t_g)\)

\(FV_{\text{Bequest}} = [1 + r_e(1-t_{ie})]^n (1-t_e)\)

\(r_g\) = Pre-tax return to the gift recipient.

\(r_e\) = Pre-tax return to the estate.

\(t_{ig}\) = Effective tax rate on investment returns to the gift recipient.

\(t_{ie}\) = Effective tax rate on investment returns to the estate.

\(t_g\) = Effective gift-tax rate.

\(t_e\) = Estate tax rate.

\(n\) = Number of periods until gift maker's death.

In this model, we introduce the new term for the effective gift-tax rate, which reduces the future value of a gift by the gift-tax amount. Notice that the future value of the bequest does not change, meaning that the lack of the exclusion benefits, all else equal, shifts the likelihood of the bequest being a better option, this is likely intuitive but is also shown mathematically by the formula.

If the after-tax returns associated with the gift and the asset to be bequeathed are the same, then the value of a taxable gift reduces to \(\frac {(1 – T_g)}{(1 − T_e)}\). If the gift tax rate is less than the estate rate, gifting can still be tax efficient.

For example, lifetime gratuitous transfers over £312,000 in the United Kingdom are taxed at 20 percent, while testamentary gratuitous transfers over £312,000 are taxed at 40 percent. The relative value of each pound of lifetime gift compared to each pound of bequest is therefore \(1.33 = \frac { (1 − 0.20)}{(1 − 0.40)}\).

Question

Assume the after-tax returns associated with the gift and the asset to be bequeathed are the same. An investor lives in a jurisdiction in which lifetime gratuitous transfers over $100,000 are taxed at 25 percent, while testamentary gratuitous transfers over $100,000 are taxed at 35 percent. What is the relative value of each dollar of lifetime gift compared to each dollar of bequest?

1. 1.05.
2. 1.15.
3. 1.33.

Solution

The correct answer is B.

Assuming the after-tax returns associated with the gift and the asset to be bequeathed are the same, then the value of a taxable gift reduces to \(\frac {(1 – T_g)}{(1 – T_e)}\). The relative value of each dollar of lifetime gift compared to each dollar of bequest is, therefore:

$$ 1.15 = \frac { (1 – 0.25)}{(1 – 0.35)} $$

A and C are incorrect. Using the stated formula in the workings gives the correct answer as 1.15.

Reading 8: Topics in Private Wealth Management

Los 8 (j) Discuss strategies for achieving estate, bequest, and lifetime gift objectives in common law and civil law regimes