I understand this section pretty well but I’ve just realised something doesn’t make sense to me and I can’t get my head around it, if someone could please guide me? It really doesn’t relate to the actual formula but the logic around it.
For a donate now vs bequest @ death situation where the giver (donor) pays the donation tax. Mathematically I understand the formula of why we include the addition of Te.Tg in the numerator. But why does this actually exist in the first place?
Example: giver has $200 and donates $100 now. assume zero return rates to both parties and tax rate of 20% for donations/estate.
When the giver donates now, donations tax is $20, after-tax value donation is $80.
When the giver dies, his estate value is now $100 (200-100) and should pay $20 ($100x20%) in estate duty tax.
The formula is implying there a deduction for the donations tax paid of $20, to his estate. I.e. that his estate value is actually now $100-$20 = $80, as a result of the donation. The difference leading to the Te.Tg (20% x 20% = 0.04)
I can’t understand why this makes sense or why it should be a deduction to his estate in the first place? Just because he paid donations tax on a previous donation, he now gets to deduct that tax from his estate which already excludes that donated value?
Using your example, if donor pays the gift tax:
- Donor transfer $100 gift to recipient (Estate value declines from $200 to $100).
- Donor pays the gift tax of 20% \times $100 = $20 from his estate (Estate value declines from $100 to $80; out of pocket expense).
And assuming no further growth in estate value, if the donor dies, the estate tax (assuming 20%) will be applied on the estate value of $80, so the estate tax is $16.
The after-tax value of the estate = $80 - $16 = $64
After-tax value of gift + estate = $100 gift + $64 estate = $164
If recipient pays gift tax:
- Gift = $100 (Donor’s estate value drops from $200 to $100)
- Recipient pays 20% gift tax (Gift value declines from $100 to $80)
Assuming no further growth, when the donor dies, the estate tax will be 20% \times $100 = $20. After-tax estate value = $100 - $20 = $80
After-tax value of gift + estate = $80 gift + $80 estate = $160
Benefit of donor paying gift tax
= Difference in after-tax value of gift & estate (donor pays vs recipient pays gift tax)
= $164 - $160
= $4 (which is 20% Te x 20% Tg x $100 gift)
Thank you for your time, quick reply and the thoroughly explained answer.
I actually thought of your exact explanation (referring to when the donor pays the gift tax) - but I fell short (or convinced myself otherwise) because the numerator of the formula still includes (1-Tg) right? So if the donations tax is coming from the donor’s “other $100” and doesn’t directly reduce the receiver’s donation, why are we still reducing the receiver’s investment value by the donations tax? Am I making sense?
The numerator would be (1-0.2)*$100 = $80 which is then grown at the recipient’s after-tax return, but you’re saying the recipient actually received $100? I completely agree though that since we’re not changing the denominator and if we were to exclude 1-Tg in the numerator, we then wouldn’t be showing a necessary tax implication so it has to be accounted for.
Hence, my prior understanding stemmed from the fact that the only difference between the donation’s tax coming from the receiver or giver, is that when it’s the giver paying the tax, the GIVER obtains a tax deduction in his estate - but they both technically reduce the receiver’s donation and therefore investment value. I was just trying to rationalize why he would get a deduction for a prior donation’s tax on his estate.
This is literally driving me crazy, sorry and thank you for your time Fino