CFA 2011-AM paper: Question 1(A)

CFA Level III
#1

Question 1(A)-tax treatment of assets in trust .Seems to me that the guy needs to be dead before cost basis is increased to current market value, but he is still alive! Can someone help me out here-am I reading it wrong http://www.cfainstitute.org/cfaprogram/courseofstudy/Documents/level_III_essay_questions_2011.pdfhttp://www.cfainstitute.org/cfaprogram/courseofstudy/Documents/level_III_guideline_answers_2011.pdf

#2

I got tripped up on this question too. The investor says he wants to minimize “total taxes”. When he is alive, it doesn’t matter is he sells the stock in the revocable or irrevocable trust, he will still have to pay the 20% capital gains taxes.

However, if he sell the stock in the irrevocable trust and keeps the remaining stock in the revocable trust, his estate will have to pay estate taxes on the assets too. The irrevocable trust does not have to pay estate taxes at all, so step-up in basis is irrelavent.

Summary:

If stocks are sold in Irrevocable trust = must pay 20% capital gains taxes and estate taxes.

If stocks are sold in Revocable trust = must pay 20% capital gains taxes, but no estate taxes.

Therefore, if stocks are sold in the revocable trust NOW, he avoids estate taxes in the future.

#3

Hi Z

Agreed -but see the guideline answer -it clearly contemplates a step-up to market value.

Also-you want to defer your tax laibility -no?

Therefore,better to sell stock in revocable trust in the future ,in estate taxes-than at present?

#4

Hi Z

Looking at your explanation again-can you explain this part:

Summary:

If stocks are sold in Irrevocable trust = must pay 20% capital gains taxes and estate taxes.

If stocks are sold in Revocable trust = must pay 20% capital gains taxes, but no estate taxes.

Bit confused by this because before this you have said:

However, if he sell the stock in the irrevocable trust and keeps the remaining stock in the revocable trust, his estate will have to pay estate taxes on the assets too. The irrevocable trust does not have to pay estate taxes at all, so step-up in basis is irrelavent.

#5

if stocks are sold in irrevocable trust

he pays capital gains tax on irrevocable tax location - since the cost basis rises to current market value.

he would pay estate taxes on his revocable trust part.

so overall it is higher taxes

but if he sold in irrevocable trust - he save on the estate taxes

but the capital gains on the irrevocable trust portion remains.

not sure if I am stating the right thing here, though

#6

Hi cpk123

This is part of my problem understanding the guideline answer-where you have said:

“since the cost basis rises to current market value”

point is he is still alive-and cost basis gets ramped up to market value at death.

but the question wants to know the most tax effecient method for a transaction executed today

#7

all the bequest stuff - in that estate planning chapter - what is it doing?

you are comparing the relative value of doing something today -

e.g. you bequest it to a relative in 5 years time, vs. put it into a charity and so on.

net effect is at the end of the horizon, but comparison is done today.

What would be the total impact of the transaction TODAY - looking at both parts together.

If he sold today from the revocable trust

Capital Gains tax = Same from either location.

At death … when the estate tax is due: Revocable - cost basis would rise to current market price. So there will be additional estate tax to pay from there. But irrevocable - there will be no estate tax. So minimization of tax will be higher if revocable trust assets are sold.

For minimizing the legal claims:

If he puts assets into a revocable trust - legal claims can still be made - since ownership is with him. But in the irrevocable trust - there is no possibility of any legal claims against it.

#8

Agree with your explanation which is a good summary of the concept-but please see guideline answer

#9

Agree with your explanation which is a good summary of the concept-but please see guideline answer

#10

that is exactly the guideline answer as well.

Please say what is different about what I have written above and what is in the guideline.

#11

The guideline asnwer is based on a ramp up to market value-eventhough he is still alive.

as mentioned, the question concerns a disposal at the present time

#12

In short-the way I see it-in steps:

a) You have an asset and you want to transfer it while minimizing taxes

b) You have 2 options -assignment into revocable trust

or an irrevocable trust. You are given the tax implications of each strcuture -so there is really no need to get into

the legal conceptual differences .

c) An assignment takes place-same value of shares in each trust (here we have to assume assingnemt at book value -if not there could well be a deemed dispocal)

The tax implications is-same tax rate regardless of whic trust shares are disposed from

Therefore answer should be : Indifferent between the two.

NOTE: Question, and this is confirmed by the answer-concerns an _ immediate disposal _

I would copy and past the answer but cannot.

So I will refer you the link below, but start with the first line and paraphraser:

Becker should sell the shares in the revocable trust……(at time of Becker’s death) the cost basis will be increased to market value

http://www.cfainstitute.org/cfaprogram/courseofstudy/Documents/level_III_guideline_answers_2011.pdf

#13

that part is fully correct. The assets in Revocable trust will have their cost basis increase to market value, but since the assets have been sold and reduced in the interim (right now) the total taxes will be minimized by that approach.

Alternative was: Assets remained in Revocable trust (full value of assets), you sold assets from the Irrevocable trust, or did the 3rd alternative (some sold from revocable, some sold from irrevocable). The Revocable trust assets would become valued at Market value - have a big capital gains component on them and thus incur more taxes.

Does what I have written above make sense?

Look at it with an example.

100$ in revocable, 100 in irrevocable.

the cost basis is actual 2 times what is in the account.

you sold 50 from revocable - when taxed at death - revocable = 100, ((100-50)*2), irrevocable = 200

you sold from irrevocable

when taxed at death - revocable = 200 (100*2), irrevocable = 50

now the 2nd one pays more capital gains tax.

#14

My point is -sale at death does not come into it.The sale out of the trusts is in the present time.Once sold, thats it

#15

Lets try it this way. Value of assets

Irrevocable : Market value 2,000,000 Cost basis = 200,000 i.e 10% of MV

Revocable : Market value 2,000,000 Cost basis = 200,000

  1. Investor looking to sell $ 1 million worth of share. If sold from REVOCABLE. Tax bill would be:

Now Death

Revocable : Capital gain $1mil - 0.1 (10% cost basis) = 0.9*20%=0.18mil $1mil - 1mil (cost=MV) = 0

Revocable : estate taxes $1mill * 20% = 0.2 Mil

Irrevocable : capital gain 2mil - 0.2 mil = 1.8mil*20% = 0.36mil

Irrevocable : Estate taxes 0

So TOTAL tax = 0.18+0.2+ 0.36= 0.74mil

  1. If sold from IRREVOCABLE. Tax bill would be:

Now Death

IRT : Capital gain $1mil - 0.1 (10% cost basis) = 0.9*20%=0.18mil $1mil - 0.1mil= 0.9*20%=0.18mil

Irrevocable : estate taxes 0

Revocable : capital gain 2mil - 2 mil =0

Revocable : Estatetaxes 2mil *20% = 0.4mil

So TOTAL tax = 0.18+0.18+ 0.4= 0.76mil

Hence better to sell it from Revocable. What you guys say?

#16

My question again-why is death relevant when it is sold now-presumably while he is still alive?

#17

Once the stock is sold-thats it, all rights, obligations, liabilities attached to it are extinguished.

#18

doubts - point of death becomes relevant - because that is the whole point of the question. They are talking “estate tax” bill + current tax bill. Total Tax reduction strategy.

#19

Thanks Rahuls. I forget, were we told that if you sell from the irrevocable trust then you have to pay cap gain taxes twice now and at death, but no estate tax?

#20

I am trying to calculate the TOTAL tax liability. Ques does say that cost basis doesn’t change & not subject to estate taxes. So if you are selling from irrevocable, you are paying capital gains now. Remaining 1 m is still there, which would be bequeathed at death. How else would you treat remaining 1m shares in this trust then?