Calculations
Calculation Description Category
Calculation Description Category
Credit Exclusion Gifts
Credit Exclusion Gifts

Credit Exclusion Gifts

Gifts made during lifetime can help minimize (or eliminate) federal estate tax otherwise payable at death in a number of different ways. Gifts that use the annual gift tax exclusion are an obvious example, because the gifts are not subject to gift tas and not subject to estate tax. Gifts that use the federal gift and estate tax unified credit applicable exclusion amount are a less obvious example, because using the exclusion during lifetime means that there is less exclusion to apply for estate tax purposes at death, so it might seem to be irrelevant whether the exclusion amount is used during lifetime or at death. However, gifts that use the exclusion can nevertheless help to avoid estate tax because future income or appreciation from the gift will not be included in the donor's gross estate, and so will avoid estate tax.

The estate tax benefit of credit exclusion gifts can be projected in two different ways:

  • One way to project the benefit is to determine the donor's life expectancy (the average number of years the donor can be expected to live), calculate the possible future growth in the value of the gift based on either an assumed rate of capital appreciation or an assumed rate of after-tax income accumulation, and then calculate what the federal estate tax (and any state death taxes) would have been if the growth were still part of the estate.
  • The other way to project the benefit is to calculate the future growth in each future year (using the same kind of assumed growth rate or income accumulation rate), and the possible estate tax on that future growth, but multiply those possible future estate tax savings by the probability of the donor dying in that future year. The sum of those possible benefits is the total probable benefit of the gift.

Webcalculators illustrates the probable benefit of making a lifetime gift using both methods.

A disadvantage of lifetime gifts of property is that the donee (recipient of the gift) receives the property with the donor's income tax basis, while if the property had been held until death the property would have received a new income tax basis equal to fair market value at death (or at the alternate valuation date six months after death, if that would reduce the estate tax otherwise payable). To compare the income tax cost of a lifetime gift of appreciating property with the estate tax benefit of excluding the appreciation from estate tax, see "Cost/Benefit of Gifts of Appreciating Property."

Estate Tax
Cost/Benefit of Gifts of Appreciating Property
Cost or Benefit of Lifetime Gifts

Cost/Benefit of Lifetime Gifts

Gifts made during lifetime can help minimize (or eliminate) federal estate tax otherwise payable at death in a number of different ways. Gifts that use the annual gift tax exclusion are an obvious example, because the gifts are not subject to gift tas and not subject to estate tax. Gifts that use the applicable exclusion amount are a less obvious example, because there is no gift tax to pay, but using the exclusion during lifetime means that there is less exclusion to apply for estate tax purposes at death. However, gifts that use the exclusion can nevertheless help to avoid estate tax if the gift is of appreciating property (such as common stock or real property) because the post-gift appreciation will not be subject to estate tax.

The disadvantage of lifetime gifts of property is that the donee (recipient of the gift) receives the property with the donor's income tax basis, while if the property had been held until death the property would have received a new income tax basis equal to fair market value at death (or at the alternate valuation date six months after death, if that would reduce the estate tax otherwise payable). So a lifetime gift of appreciating property has a possible estate tax benefit because post-gift apprecation is not subject to federal estate tax, but has a possible income tax cost because all pre-death appreciation (including pre-gift appreciation) may be subject to tax as capital gains.

One way to compare the income tax costs with the estate tax benefit is to project the future value of the property using an assumed rate of growth in value, then calculate both the possible estate tax on that post-gift growth and the possible income tax on the pre-gift and post-gift appreciation. The difference between the possible estate tax on the post-gift appreciation and the possible income tax on all of the pre-death appreciation is the net benefit of the lifetime gift.

Two additional calculations are possible:

  • If the property has a basis that is less than current fair market value, then there is a current income tax cost but only a future estate tax benefit, and the net benefit will be negative if the donor dies soon after making the gift. There will be "break-even" point at which the estate tax benefit exceeds the income tax cost, and it is possible to calculate that break-even point and the probability of the donor living to that point, using the same mortality table used by the Internal Revenue Service for life estate and annuity calculations.
  • By calculating the possible net benefit in future years, and the probability of the donor dying in each of those future years, it is possible to add those future probabilities together into a total net probable benefit for the lifetime gift.

The net benefit of the lifetime gift increases if the donor's basis in the property is nearer current market value, the assumed rate of growth is larger, or the donor is younger. The net benefit decreases if the property has a lower basis, the growth rate is lower, or the donor is older.

These calculations do not take into account the possibility that the property might not be sold for many years post-death, and so the tax on the capital gains might be deferred for many years (or avoided entirely if the beneficiary or beneficiaries who inherit the property should die before selling the property, so that the property receives a new income tax basis and the tax on the appreciation disappears). There is also the possibility of future tax law changes that would change the projected estate tax or income tax liabilities.

Estate Tax
Cost/Benefit of Grantor Trusts
Grantor Trusts

Cost/Benefit of Grantor Trusts

A "grantor trust" is a trust which is considered to be "owned" by the grantor (or creator) of the trust (or a beneficiary of the trust) for federal income tax purposes. When the grantor or beneficiary of a trust is treated as the "owner" of a trust (or a portion of the trust), that grantor or beneficiary must include the income, deductions, and credits of the trust (or portion of the trust) on that person’s individual income tax return, and not on the tax return of the trust.

There are a number of different ways that a trust can be a grantor trust, and all of those different ways are too numerous and complicated to be described in detail, but they represent the judgment of Congress that a grantor who has retained a certain level of control over the income or principal of a trust should be treated as the owner of that trust for income tax purposes. The simplest example is a revocable trust. If the grantor of a trust can revoke the trust, then the trust should be ignored for income tax purposes. Similarly, a beneficiary who can withdraw the income and principal of a trust should be treated as the owner of that trust.

That a revocable trust is a grantor trust does not create any opportunities for estate or gift tax planning, because the creation of a revocable trust is not a completed gift, and the trust is still part of the gross estate of the grantor for federal estate tax purposes (and also subject to Pennsylvania inheritance tax). However, there are other powers that the grantor can retain to create a grantor trust other than the power to revoke, and the IRS has issued favorable gift and estate tax rulings on the use of those powers, so a trust can be a grantor trust even when the trust is irrevocable.

The most commonly used power to make an irrevocable trust a grantor trust is for the grantor of the trust to retain the power, exercisable in an individual and not a fiduciary capacity, to reacquire the trust principal (or corpus) by substituting other property of equivalent value. If the grantor creates an irrevocable trust and retains the power (in a nonfiduciary capacity) to require the return of property held in the trust in exchange for property of equal value, the trust is a grantor trust even if the grantor has no other interest or power in the trust. And the IRS has issued public rulings (on which taxpayers can rely) holding that the retention of a power of substitution does not cause the trust assets to be included in the grantor's gross estate, and so the trust is not subject to federal estate tax at the grantor's death.

Grantor Trust Benefit

The benefit of a grantor trust comes from who pays the tax on the trust's income and gains. The IRS has ruled that, when a trust is a grantor trust, the grantor is liable for the tax on the trust’s income. Therefore, because the grantor is paying his own tax liability and not the liability of the trust, the payment of the tax by the grantor is not a gift by the grantor to the trust or its beneficiaries.

The IRS ruling is not limited to any particular kind of income and applies to both capital gains and ordinary income. It also makes no difference whether the income or gains are distributed or accumulated. This means that the grantor of a grantor trust can pay the income taxes for income paid to children and grandchildren, or accumulated for their future benefit, without making a taxable gift.

So, if a trust has $20,000 of income and would otherwise have to pay $6,444 of federal income tax to accumulate that income (at 2017 rates), but the trust is a grantor trust and the grantor pays the tax on the income, the grantor has effectively made a $6,444 gift to the trust without payment of any gift tax. The trust will continue to earn income for which the grantor will have to pay additional taxes each year, so the grantor can indirectly add substantial sums to that trust during his or her lifetime by paying the income taxes for the trust.

Possible Income Tax Costs

There may be a small income tax cost to having income taxed to the grantor rather than the trust or its beneficiaries, because the grantor may be in a higher income tax bracket, but this cost may be small in comparison to the gift and estate tax benefit, particularly if the income would otherwise be accumulated, because the tax brackets that apply to trusts are much smaller than the tax brackets that apply to individuals, and so a trust reaches the top income tax rate very quickly. For example, under current (2017) law, a trust reaches the top income tax rate with only $12,500 of income, and the difference between the tax on that income ($3,232.50) and the tax at the top income tax rate of 39.6% ($4,950) is only $1,717.50. So it doesn't take much of a gift tax benefit to overcome that income tax cost.

Further, if both the grantor and the trust are investing in securities that pay qualified dividends that are taxed as capital gains and not ordinary income, then the difference between the income tax payable by the trust as a separate taxpayer (non-grantor trust) and the income tax payable by the grantor will be even less.

An additional factor is that a trust accumulating income might also have to pay the 3.8% tax on net investment income under IRC section 1441, which the grantor might or might not have to pay because individuals have higher threshold amounts for that tax. So it is possible that the income tax paid by the grantor might be more than the income tax that would have been paid by the trust, while the tax on net investment income would be less, off-setting some (or all) of the income tax increase.

Comparing the Costs and Benefits

Webcalculators illustrates the gift tax benefit and income tax costs by calculating the income earned by a trust and comparing (a) the income taxes payable by the trust as a separate taxpayer (a non-grantor trust) and (b) the additional income taxes that would be payable by the grantor. The income tax cost is the difference between the cumulative difference in the income taxes paid by the two different kinds of trusts, plus the lost income, and the estate tax benefit is the difference between the compounded after-tax value of the two trusts.

Estate Tax
Value of Income and '5 & 5' Power
Value of Five-and-Five Power

Value of Income and 'Five and Five' Power

A common feature of a trust that gives liberal benefits to a beneficiary is to give the beneficiary all of the income and, in addition, the power to withdraw each year either five percent of the value of the trust or $5,000, whichever is the greater amount. (Those limits are intended to conform with a provision of the Internal Revenue Code that states that, if the beneficiary does not exercise the withdrawal right, and the right lapses, the lapse is not a gift by the beneficiary to the trust.)

These "5&5" powers must sometimes be valued for tax purposes, and this calculator determines the value of the combined income and principal withdrawal rights in accordance with section 7520 of the Internal Revenue (which applies to the valuation of life estates, remainders, and annuities). Valuations under section 7520 rest upon two assumptions: (a) a rate of interest that is applied to discount future amounts back to present value, and (b) a mortality table that is used to determine the probability that a person with survive to a particular age, or die before reaching that age.

The valuation of a 5&5 power is done in the following steps for each possible future year:

  • The income of the trust is assumed to be the principal of the trust times the 7520 rate.
  • The withdrawal right is either 5% of the principal of the trust or $5,000, whichever is greater.
  • The present value of the income and withdrawal right is the sum of those rights multiplied by a factor that represents the present value of $1 to be paid only if the beneficiary is living, and so discounted by both the interest the $1 could have earned at the 7520 rate and the probability the beneficiary could die before receiving those interests.
  • Those present values, for all years from year one to the year in which the beneficiary would reach 110 (which the mortality table considers to be the oldest possible age), are added up, and become the total present value of all future income and withdrawal rights.
Estate Tax
Gift Tax on Net-Net Gifts
Net_Gift_Expl

Gift Tax on Net-Net Gifts

Net Gifts

Under the federal gift tax system, the donor pays the gift tax on a gift, and not the recipient ("donee") of the gift. In the classic "net gift," the recipient agrees to pay the gift tax on the gift. Because the recipient is paying an obligation of the donor, essentially paying money back to the donor, the value of the gift is reduced by the gift tax that must be paid by the recipient.

The classic net gift does not result in any actual tax savings, because the donor is simply making a smaller gift, and is usually done because the donor is making a gift of real property, a closely held business, or other assets that the donor doesn't wish to sell and the recipient has the cash necessary to pay the gift tax and is willing to pay the gift tax in order to get the property being given.

Net-Net Gifts

In a newer form of net gift, usually referred to as a "net-net gift," the recipient agrees to pay not only the gift tax on the gift, but the estate tax that might result if the donor dies within three years of making the gift. (If the donor dies within three years of the gift, then the gift tax that was paid on the gift becomes part of the gross estate for federal estate tax purposes and therefore subject to estate tax. Congress enacted this rule in order to treat gifts made shortly before death as in the same way as gifts made at death, because gift taxes paid on lifetime gifts are obligations of the donor and so reduce the donor's taxable estate while the estate tax does not reduce the taxable estate. See details for a more complete explanation.)

Unlike the classic net gift, the net-net gift produces an actual tax savings, because the value of the gift is being reduced by an amount that the recipients of the gift have not actually paid, and might never pay if the donor survives the three-year period after the death. And, even if the donor does die within the three-year period, the resulting estate tax is still less than it would have otherwise been because the gift tax that was paid was less than it otherwise would have been.

Based on a court opinion upholding the validity of a net-net gift, it would appear that the present value of the estate tax that might be paid should be valued in the same way as a contingent remainder (the present value of $1 payable upon the death of an individual, but only if the individual dies within the three-year period), applying the rules of I.R.C. section 7520, which generally controls the valuation of life estates, remainders, and annuities.

Semi-Net Gifts

It would also seem to be possible for the recipient of a gift to agree to pay the estate tax that might be owed on the gift tax even though the donor will pay the gift tax and not the donor. (In other words, the donor is willing to pay the gift tax, but wants the recipients to pay the estate tax on the gift tax.) This might be called a "semi-net gift." As explained above, the payment of the gift tax by the recipients does not produce any tax savings, but usually reflects a choice about who is best able to bear the burden of the gift tax that must be paid. A "semi-net gift" should be produce the same gift tax savings as a net-net gift in those cases in which the donor is the one best able to pay the gift tax.

Income Tax Considerations

A net-net gift also has income tax consequences:

  • As with all gifts, the recipient receives the property gift with the same income tax basis as the donor, increased by any gift tax paid and by any other consideration paid by the recipient. So a net-net gift of appreciated property may later result in a capital gain that would not have happened if the gift had not been made and the property had received a new basis upon the death of the donor. (See the "Cost/Benefit of Lifetime Gifts" calculator for more information on this issue.
  • A net gift or net-net gift is treated as part sale and part gift, and may result in taxable gain to the donor if the consideration paid by the recipient (the gift tax paid by the recipient and the present value of the agreement to pay the possible estaet tax on the gift tax) exceeds the donor's basis in the property.
Gift Tax
Income Tax on Estates and Trusts
Fiduciary Income Tax

Income Tax on Estates and Trusts

Trusts and estates file income tax returns that are known as "fiduciary returns," Form 1041. (A "fiduciary" is a person who holds property for the benefit of other persons. Common types of fiduciaries are executors or administrators of decedent's estates, trustees of trusts, and guardians or conservators of the estates of minors or persons declared to be legally incapacitated.)

Estates and trusts are often described as "pass-through entities" because the beneficiaries of the trust are taxed on the income that is distributed to them and the trust is taxed on the income that is not distributed. The character of the income that is distributed generally has the same character that is received by the estate or trust, so if a trust that receives qualified dividends as income distributes all its income, the income received by the beneficiary is taxed as qualified dividends.

The taxation of estates and trusts is similar to the taxation of individuals in the following ways:

  • Estates and trusts can claim deductions for some of the same things for which individuals can claim deductions, such as interest that is paid, and state and local taxes. And, like other taxpayers, the expenses of producing income must be allocated between taxable and tax exempt income and the expenses attributable to exempt income are not deductible.
  • The undistributed taxable income of estates and trusts is subject to progressive tax rates that are similar to the tax rates that apply to individuals, and that are based on tax brackets that are indexed for inflation like the tax brackets of individuals, but there is no 10% bracket and the brackets are much smaller than those for individuals, with the top tax rate of 39.6% applied to income in excess of $12,400 (for the year 2016).
  • The long-term capital gains of estates and trusts are subject to a top tax rate of 15%, qualified dividends are treated like long-term capital gains, and the tax on capital gains is calculated in the same way as for individuals.
  • The capital losses of an estate or trust can only reduce other taxable income by $3,000.
  • Estates and trusts are subject to the 3.8% tax on net investment income, just like individuals.

There are also a number of differences between the income taxation of estates and trusts and the income taxation of individuals:

  • Estates and trusts can claim a charitable deduction, but only in the governing instrument (the will or trust document) requires the payment to the charity and only if the payment must be made out of the income of the estate or trust.
  • The expenses of an estate or trust that are for the collection of income or the management or preservation of income-producing property (which covers most of the costs of administering an estate or trust) is deductible as a "miscellaneous itemized deduction" and, like the same kinds of deductions for an individual, are only deductible to the extent the expenses exceed 2% of "adjusted gross income." However, estates and trusts can deduct costs which would not have been incurred if the property were not held in the estate or trust. So, for example, fiduciary fees are fully deductible, but investment management fees are subject to the 2% "floor."
  • Estates and trusts are entitled to a deduction for income distributions to beneficiaries (and the beneficiaries must then include the distributions in their own income), but the deduction is limited by the "distributable net income" of the estate or trust. (See below for a more detailed explanation of distributable net income.)
  • Estates and trusts have a deductible exemption that is like the personal exemption for individuals, but it is much smaller, and not indexed for inflation.
    • Estates are entitled to an exemption of $600.
    • Trusts that are required to distribute all of their income each year are entitled to an exemption of $300. (Because all income is distributed currently, the exemption usually applies only to capital gains, which are usually not considered to be income and so not distributed.)
    • Trusts that can accumulate income are entitled to an exemption of $100.
Income Taxes
Required Minimum Distribution
Required Minimum Distributions

Required Minimum Distributions

Qualified retirement plans and individual retirement accounts (IRAs) were intended by Congress to help support the plan participant or account owner during retirement, and not as a tax-deferred investment account for the benefit of future generations. Therefore, section 401(a)(9) of the Internal Revenue Code, and the regulations that have been adopted for that section, require distributions from retirement plans during the plan owner's lifetime and, afher the owner's death, complete distribution either within five years after the owner's death or, if there is a "qualified beneficiary," within that beneficiary's lifetime.

The minimum distribution requirements can be summarized as follows:

  • The owner must begin taking distributions in the year in which the owner reaches age 69-1/2. (The owner is age 60-1/2 in the year in which falls the date that is six months after the owner's 60th birthday.) That first distribution must be made before April 15 of the following year. Required distributions in the years after the year in which the owner turns 69-1/2 must be made before the end of the year (i.e., by December 31).
  • During the owner's lifetime, required distributions are (a) the value of the account at the beginning of the year, divided by (b) the applicable life expectancy. The applicable life expectancy is calculated based on ages at the end of the year, as follows:
    • If no "qualified beneficiary" has been named, the applicable life expectancy is taken from the "Uniform Lifetime Table," which is a joint-and-survivor life expectancy table based on the owner's age and a second age 10 years younger.
    • If a spouse is named as a qualified beneficiary and the spouse is more than ten years younger than the owner, the applicable life expectancy is a joint-and-survivor life expectancy calculated from the owner's age and the spouse's age.
  • Following the account owner's death:
    • If there is no qualified beneficiary, all distributions must be completed within five years.
    • If there is a qualified beneficiary and the owner died before the required beginning date for distributions (e.g., before the owner has reached age 69-1/2), the required distributions are based on the qualified beneficiary's life expectancy.
    • If there is a qualified beneficiary and the owner died after the required beginning date for distributions, the required distributions can be based either on the owner's age or on the qualified beneficiary's age, as the beneficiary elects.

A "qualified beneficiary" must be either an individual (or group of individuals) or a trust which meets certain requirements. When there is more than one qualified beneficiary, the age of the oldest beneficiary is used to calculate required distributions. However, following the death of an account owner, the identity of the "qualified beneficiary" is determined after nine months, so accounts and plans can be divided into new accounts among multiple beneficiaries and the required distributions calculated for each beneficiary's separate account.

Retirement
Interest on Federal Taxes
Interest on Federal Taxes

Interest on Federal Taxes

Underpayments and overpayments of federal taxes result in the imposition of interest that is compounded daily until the tax (and interest) is paid. This means that the annual interest rate is divided by 365 (366 in a leap year) to determine a daily interest rate, and then the daily interest rate is applied each day to both the tax that is owed and the interest has accrued.

Although this system might sound complicated, it actually simplifies the accounting for taxes and payments, because it lo longer makes any difference whether payments are applied to the tax or the accrued interest.

The interest rate on underpayments is calculated by the Internal Revenue Service and published quarterly, based on the applicable federal short-term rate for the first month of the quarter, rounded to the nearest whole percentage. (The applicable federal short-term rate for a month is the average yield on federal securities with a maturity of less than three years during the preceding three months.) In addition:

  • The rate for overpayments of taxes by individuals (and estates and trusts) is the same as the rate for underpayments.
  • The rate for overpayments of taxes by corporations is one percentage less than the rate on underpayments.
  • The rate for overpayments by corporations in excess of $10,000 is 2.5 percentage points less than the rate on underpayments.
  • The rate for underpayments by corporations in excess of is 2 percentage points more than the rate on underpayments.

The date on which interest begins to accrue on a tax (or penalty) depends on the type of tax (or penalty).

  • When a tax is due with a return, interest on underpayments generally starts to accrue with the due date of the return, without regard to any extension of time. That is:
    • For income tax returns of individuals, estates, and trusts, the 15th day of the fourth month following the end of the tax year (which is April 15th for calendar year taxpayers);
    • For income tax returns of corporations, the 15th day of the third month following the end of the tax year (which is March 15th for corporations which file returns based on the calendar year);
    • For estate tax returns, the date that is nine months after the date of death (or the last day of the month if the date of death was on the 30th or 31st and there is no 30th or 31st in the month the return is due);
    • For gift tax returns, April 15th of the year following the year in which the gifts were made.
  • In most cases, interest on penalties and additions to taxes (such as estimated tax penalties, penalties for failure to file, or penalties for failure to pay taxes) does not accrue until there is a notice to the taxpayer of the penalty or addition, and no interest is imposed if the penalty or addition is paid with 21 days of the date of the notice.
  • For refunds, interest usually does not start to accrue until 45 days after the claim for the refund is filed or, in the case of a return that is filed before the due date of the return, 45 days after the return was due. (So, if an individual income tax return is filed claiming a refund before the April 15th deadline, interest on the refund does not begin to accrue until May 30th.
Utility
Interest on Pennsylvania Taxes
Interest on Pennsylvania Taxes

Interest on Pennsylvania Taxes

Underpayments and overpayments of Pennsylvania taxes result in the imposition of interest that is simple interest, and not compounded, regardless of how long the tax (and interest) remain unpaid.

This can complicate the accounting for taxes and payments, because it makes a difference whether payments are applied to the tax or the accrued interest. Generally speaking, payments are applied first to the tax owed, so payments will stop the accrual of additional interest even though the interest already imposed remains unpaid.

The interest rate on underpayments and overpayments is the same as the interest rate on underpayments of federal tax, but is only updated annually, in January, even though the federal rates can change quarterly. In addition:

Utility