Valuation

Capitalization of Income (Valuation)


Market value is the price a hypothetical willing buyer and willing seller would agree upon, assuming both parties have reasonable knowledge of the relevant facts and are bargaining at arms' length. No formula exists that applies to all assets and that will be accepted without question by both the IRS and the courts.

Converting the projected flow of income from a business or asset into its present value, i.e., "capitalizing the income," provides a simple, reasonably accurate, and commonly accepted way of estimating fair market value.

The concept of income capitalization is simple: determine what amount of income is realistic and proper under the circumstances and then apply a capitalization rate that meets the same criterion. In essence, the capitalization rate is the desired rate of return; the rate of return an investor would be willing to accept for the given level of risk.

A high-risk investment would equate to a high capitalization rate (which in turn results in a lower value). The asset or business is then presumed to be worth the result when adjusted earnings are divided by the capitalization rate.

But transforming theory into practice is often complex and frustrating. The brief comments below, pertaining to "adjusting" the earnings and selecting the appropriate rate of return may help:

1. Adjustments to "income" (rents, dividends, and business profits). In the case of a business, use five-year average after-tax profits:

  1. Add back excessive salaries

  2. Reduce earnings if salaries were too low

  3. Add back bonuses paid to stockholder-employees

  4. Add back excessive rents paid to shareholders

  5. Reduce earnings where rents paid to shareholders were below what was reasonable in the market

  6. Eliminate non-recurring income or expense items

  7. Adjust for excessive depreciation

  8. Adjust earnings for major changes in accounting procedures, widely fluctuating or cyclical profits, or abnormally inflated (or deflated) earnings.

  9. If there has been a strong upward or downward earnings trend, weight the average to obtain a more realistic appraisal of the company's prospects.


2. Determine the "capitalization rate", i.e., the level of return the investor wants to receive from the business or other asset. The capitalization rate is the amount that is divided into adjusted earnings). The result is the same as multiplying the reciprocal of the rate, (the result of dividing the number one by the capitalization rate). In other words, you obtain the same result by multiplying $100,000 of income by 5 as you do if you divide the $100,000 of income by .20.

deciding on a capitalization rate, consider the following:

  1. smaller capitalization rate will result in a higher value. A higher capitalization rate results in a lower value. You can check this by examining the value of a business with an adjusted after tax income of $50,000 a year capitalized at 6 percent (that is, divided by .06), $833,333, and comparing the result with one capitalized at 15 percent (i.e. divided by .15), $333,333.

  2. Stable businesses with large capital asset bases and established goodwill should be less risky investments. Use a lower capitalization rate than if you were valuing a small business with little capital, financial history, or management depth.

  3. A risky business, a new business, or a business that stands or falls on the presence or absence of one or two key people should generally be assigned a higher capitalization rate. An investor purchasing this type of business would want a high rate of return as a reward for that risk. (Another way to say the same thing is that such an investor would not make the investment unless a rapid return of capital through a high-income stream was expected).

  4. There is neither an official IRS mandated capitalization rate nor a "correct" one. Even the IRS uses different rates at different times and under different circumstances. Insist on a capitalization of income illustration showing a high-low range of values since there is no "correct" exact value.






Valuation

Valuation through Comparable Stock


Often, the value of a closely held business can be determined by referencing a comparable company whose stock is listed and actively traded on a securities exchange or on the over-the-counter (OTC) market. This approach is based on the theory that if two companies are more-or-less comparable, and the listed company is selling for five times earnings, then the closely held firm's stock is also worth five times its earnings.

Finding an appropriate comparable company requires research and careful consideration. Similarities in product lines, size, growth, and profitability are indications of comparable companies. Inspecting balance sheets and income statements is also recommended. Trade magazines are a good place to begin research.





Valuation

Book Value Method


This calculation determines the value of a corporation's common stock by subtracting both liabilities and the par value of preferred stock from the value of the firm's assets. It then arrives at a per share value by dividing the number of common shares outstanding into the adjusted book value.

Essentially, book value is "assets minus liabilities." Book value is often a good starting point when calculating the value of a closely held corporation.

This is especially true for the following businesses:

  1. The business is predominately an asset holding company (e.g., an investment company).

  2. The business is a real estate development business whose assets are the primary profit-making factor.

  3. The business relies primarily on one person.

  4. The business is currently (or close to) liquidating.

  5. The business is very competitive, but only marginally profitable. In this case, examining past profits is an unreliable method of predicting future earnings.

  6. The business or its assets are relatively new.

  7. The business is likely to merge with another firm.

  8. The business is burdened with large deficits.

  9. assets are recorded in the company's books at "cost" rather than "market value". For example, a closely held investment company usually records their marketable securities at cost. This creates a discrepancy between the book value and the actual worth of the business.

  10. When assets are recorded in the company's books at an excessive depreciation rate. For example, an operating company purchases machinery or equipment originally costing $1,000,000 but records a depreciated value of $300,000. The actual value of the equipment may be significantly more or less than either of these figures.

  11. When a firm's balance sheet fails to disclose potential lawsuits, unfavorable long-term leases, or other such items.

  12. When assets with significant economic value have been completely written off.

  13. When the business has carried franchises, goodwill, and other such assets on the books at a modest cost.

  14. When the business has trouble collecting accounts receivable.

  15. When the firm's inventory contains goods that are either obsolete or not readily marketable.

  16. When the business has insufficient working capital or liquidity position.

  17. When the firm has a significant number of long-term debts.

  18. When the business's retained earnings are high only because they have accumulated over a substantial period. This indicates a business with low current earnings and minimal potential for increasing its earnings.


In addition to the above adjustments, the value of any other class of stock with a priority as to dividends, voting rights, or preference to assets in the event of a sale or liquidation must be deducted from the value. For example, a common stock owner does not realize the value of the assets until preferred stock owners have been satisfied.

Book value should be used in conjunction with other valuation methods and not as the only method of valuing a closely held business.

Note: Be sure not to "double count" an asset when combining two or more methods.

Book value should not be used when capital plays a minor role in profit making or where you are valuing the stock of a party who does not have the voting power to force liquidations. In that case, book values have little relevance.




Valuation

Goodwill Valuation (Valuation)


A closely held business should (and often does) produce an income in excess of the amount that could be expected from the mere employment of the capital its shareholders have invested. That additional amount of income is derived from an intangible value in the business, a value in excess of the total value of the tangible assets. This is called "goodwill."

By capitalizing this "earnings attributable to intangibles," i.e., by dividing the additional profits generated by the firm's goodwill by an appropriate rate, it is possible to estimate goodwill value. If this amount is then added to book (net tangible asset) value, an estimated total business value can be found.

Some of the elements that may comprise a firm's goodwill include:

1. Location of the business

2. Reputation of the business

3. Public recognition of the company's name

4. Lists of customers and prospects owned by the business

5. Management effectiveness and depth

6. Sales, operations, and accounting skills

7. Employee morale

8. Position of the business relative to competitors

9. Other factors that generate income in excess of that amount which could be expected after multiplying the value of tangible assets by a reasonable rate of return.


Note that goodwill does not include the portion of profits attributable to the corporation's ownership of patents, copyrights, formulas, or trademarks, even though they are intangible, since these are all specifically identifiable.

Goodwill, as is the case with other valuation formulas and procedures, should be used only as a guideline along with other valuation methods and not as the sole determinate of value. Goodwill has minimal relevance to the valuation of most investment companies since they usually do not have large amounts of intangibles. Officially the IRS does not give strong credibility to goodwill (although the IRS still insists that goodwill must be taken into account in the valuation process).




Valuation

Key Employee Valuation


Often, the loss of a key employee adversely affects the earning potential (and sometimes the stability) of a business. Closely held corporations are especially vulnerable as their profits rely on the ability, initiative, and business connections of one employee or a small group of employees.

A common method of calculating the economic effect of the loss of a key employee is the discount approach. This approach applies a percentage discount to the fair market value of the business.

The discount approach requires an appropriate discount factor. Some authorities believe that if the business will survive the loss of the key employee and, in time, will hire a competent replacement, an appropriate discount factor is 15 to 20%. If the business will fail, or will be placed in jeopardy from the loss of the key employee, an appropriate discount factor is 20 to 45%. The officers of the company and the firm's accounting and legal advisors, however, should determine the exact discount factor. Consider the following when determining the discount factor:

  1. How long will it take the replacement to become as efficient as the lost key employee?

  2. How much will it cost to locate, situate, and train a replacement? Will the new employee want a higher salary?

  3. Is the replacement likely to make costly mistakes during the training period?

  4. Will the loss of the employee result in a loss of clientele?

  5. What percent of the firm's current net profits is attributable to the key employee?


While there are other methods of calculating the value of a key employee's contribution to a corporation, the discount approach is a quick and effective method that sidesteps many of the difficulties posed by alternative methods.




Valuation

Special Use Valuation


If certain criteria are met, an executor may choose to value property based on its actual use instead of on its "highest and best" use. In some cases, this tactic reduces the value of farm and business real property. In 2007, the value may be reduced up to $940,000. In prior years, the limit was lower ($750,000 for 1998, $760,000 for 1999, $770,000 for 2000, $800,000 for 2001, $820,000 in 2002, $840,000 in 2003, $850,000 in 2004, $870,000 in 2005, and $900,000 in 2006).

While several methods of valuing this property exist, the valuation method used by this calculation is the most favorable and conclusive method. This method's formula, shown below, capitalizes the potential flow of income from comparable property.

Special Use Value = (a -b) / c

Where:

a = Average annual gross cash rental for comparable land.
b = Average annual state and local real estate taxes for such comparable land.
c = Average annual effective interest rate for all new federal land bank loans.

The income to be capitalized is the average annual gross cash rental income (for five years prior to the decedent's death) minus the average annual state and local real estate taxes (for the same five year period) applicable for that comparable land.

To qualify as comparable land, the land must be used for farming purposes and must be located in the same area as the farmland to be valued.

The executor is not permitted to use cash rentals from the farm to be valued. Rentals used from comparable farmland must have been the result of arms' length bargaining.

The capitalization rate is the average billing rate charged on new agricultural loans to farmers in the farm credit district where the qualified property is located. For example, Rev. Rul. 2000-26 sets an interest rate of 9.82% for the Columbia Farm Credit Bank District for 2000 valuations.






Valuation

Financial Planning Ratios


Ratios are frequently used in financial analysis. A ratio is an equation that identifies the relationship of one quantity to another, such as current assets ($20,000) to current liabilities ($8,000). Ratios are also expressed as percentages, such as 1 to 5 equals 20%.

Ratios are used to compare the business to be valued to:

  1. The same business's ratio in previous years,

  2. The ratios of competitors, and

  3. A goal set by the business's owners and financial advisors.


Ratios are often used to measure the following:

  1. The business's ability to meet its short-term obligations (liquidity ratios).

  2. The business's long-range ability to provide security for creditors (debt, coverage, or leverage ratios).

  3. The business's ability to generate a profit (performance ratios).

  4. The business's ability to use assets effectively (utilization ratios).

  5. The business's marketability (market measure ratio).


Accurate data is needed to calculate accurate ratios. This data can be obtained from company balance sheets and income statements.






Tools of Estate Planning

Includible Portion of CRAT, CRUT, GRAT, or GRUT


This calculation computes the portion of a charitable remainder annuity trust (CRAT) or charitable remainder unitrust (CRUT) that may be includible in the grantor's gross estate if the grantor has retained the annuity or unitrust interest, or the portion of a grantor retained annuity trust (GRAT) or grantor retained unitrust (GRUT) that may be includible in the grantor's estate if death occurs before the trust term ends. The inclusion is calculated in accordance with regulations under IRC §2036 that were published in T.D. 9414, 73 F.R. 40173 (7/14/2008) and became effective when published.

Under the regulations, the IRS will not attempt to apply IRC §2039 to require inclusion of any part of a CRAT, CRUT, GRAT, or GRUT.

In the case of a CRAT or GRAT, the inclusion is based on the amount of principal needed to produce an income equal to the annuity amount, which is calculated by dividing the annuity by the §7520 rate.

In the case of a CRUT or GRUT, the includable amount is determined in three steps as follows (i.e., the computation performed by the software):

  1. Find the "adjusted payout rate" for the unitrust amount

  2. Find equivalent income interest rate, which is the adjusted payout rate from step one divided by (1-adjusted payout rate).

  3. Find includable portion, which is the step 2 equivalent income interest rate divided by the §7520 rate.


To "bullet-proof" the tax savings, life insurance in the amount of the expected estate tax savings can be purchased by an adult beneficiary or by the trustee of an irrevocable trust.




Tools of Estate Planning

Self-Canceling Installment Note (SCIN)


An installment note is a promissory note (evidence of debt) usually issued in conjunction with the sale of property where at least one payment is to be received by the seller after the close of the taxable year in which the sale occurs. A self-canceling installment note is an installment note that contains a provision under which the buyer's obligation to pay automatically ceases in the event a specified person, called the measuring or reference life (usually the seller), dies before the end of the term of the note.

When Is It Used?
An installment note is useful when a client owns a highly appreciated asset he would like to sell and wants to spread the recognition of and taxation on the gain over a term of years. (However, any gain attributable to excess depreciation that is subject to recapture under IRS §1245 or §1250 is fully recognized in the year of sale. Also, under installment sale rules, all gain is recognized in the year of sale, even if payments on the note extend over several years, if the subject of the note is publicly traded stock.) Installment notes with a self-canceling provision are especially useful when one family members, typically a parent or grandparent, wishes to transfer property to another family member, typically a child or grandchild, with minimal gift and estate tax consequences.

What Are the Estate and Gift Tax Consequences?
In general, the fair market value of any unpaid installment obligation on the date of death is included in the estate of the seller. However, if the note contains a properly designed self-cancellation provision, the buyer is under no obligation to make any further payments after the seller's premature death, which leaves no unpaid balance to be included in the seller's estate. The self-canceling feature can be an effective means of transferring property to family members without estate or gift tax consequences in the event of the death of the seller-transferor before the last potential payment has been made under the terms of the installment note.

How Should a SCIN Be Structured?
A SCIN will avoid adverse gift and estate tax treatment only if the self-cancellation provision is properly designed. The courts have held that:

  1. The cancellation provision must be bargained for as part of the consideration for the sale.

  2. The purchase price must reflect this bargain either with a principal risk premium (above market sales price) or an interest rate premium (above market interest rate).

  3. The seller may not retain any control over the property being sold after the sale.


If the self-cancellation provision is not properly designed, the seller may be deemed to have made a part-sale part-gift. If any of the transfer of the remainder interest (the canceled payments) is considered a gift, the entire value of the property sold, less the consideration actually paid, will be included in the decedent's gross estate. This problem can be avoided by structuring the note as much like a market note as possible, except for the principal or interest rate premium. Although not all issues of valuation and proper design have been resolved by regulation or by the courts, most authorities feel the debt instrument and the sales contract should both include the self-cancellation clause. To avoid retained controls, the sales contract and/or note cannot place any restrictions on the use of the property by the buyer, including any restrictions on subsequent sales. (In general, a subsequent sale of the property by the buyer within 2 years of the original sale will trigger recognition of any remaining deferred gain by the original seller, even if the note has not been fully repaid.) Furthermore, it is advisable to avoid using the property sold as collateral for the note so the seller has no right to reacquire the property sold under any circumstances.

What Interest Rate or Discount Rate Should be Used in a SCIN?
Selecting the appropriate market rate of interest is perhaps the most difficult step in the process of designing and implementing a SCIN.

For income tax purposes, self-canceling installment notes are subject to the installment sale rules. Although these rules are complex, the general rule is that the interest rate on an installment sale note must at least equal the appropriate applicable federal rate (AFR) with semiannual compounding. Failure to follow these rules may result in reapportionment of interest and principal of scheduled payments and imputation of interest income to the seller, even in periods in which he or she may not have received payments.

The choice of whether to reflect the risk premium as an increase in the sales price (principal risk premium) or as an increase in the interest rate (interest rate risk premium), depends on the relative tax situations of the buyer and seller. If the risk premium is reflected in the sales price (principal risk premium), the seller will report more of each payment as capital gain and less as interest income. The buyer will pay less interest (which is deductible if the interest is investment or trade or business interest and not personal interest), but his or her basis will be higher. If the property is depreciable and the buyer and seller are in similar tax brackets, the principal risk premium may be preferred to give the buyer a larger depreciable base.

However, if the property is not depreciable, the buyer may prefer the interest rate premium where the basis is lower but deductible interest payments are higher.

Theoretically, some appropriately weighted combination of principal risk premium and interest risk premium would be acceptable. A weighted combination risk premium may be determined using the program in a two-step fashion.

  1. Compute the principal risk premium and interest rate risk premium using the appropriate market rate of interest.

  2. Choose an interest rate risk somewhere between the market rate and the risk-premium-adjusted interest rate computed in the first pass and enter it as the market rate of interest in the data input section (leave the §7520 as it is). The resulting principal risk premium will be lower than that computed originally using the market rate of interest. The summary statement and repayment schedule for the installment note with principal risk premium will now reflect the combined risk premiums. The interest rate premium is equal to the difference between the market rate and the second (higher) rate entered. The revised and lower principal risk premium is reflected on the summary statement. The repayment schedule will show the effects of each risk premium the allocation of interest, gains and basis recovery.





Tools of Estate Planning

Private Annuity


This calculation determines the annual payment for a "private annuity." It also calculates the tax-free portion of each payment, the portion that qualifies for capital gains treatment, and the portion reportable as ordinary income.

Under a private annuity, an agreement is signed. That document requires one party (the transferor-annuitant) to transfer ownership of property to another party (the transferee-buyer). In return, the transferee-buyer makes periodic (typically monthly, quarterly, semi-annual, or annual) payments to the transferor for a specified period (usually the lifetime of the transferor or the transferor and transferor's spouse).

The private annuity is a useful tool for an individual who wants to spread gain from a highly appreciated asset over his or her life expectancy.

The private annuity is also as a useful federal estate tax saving tool because, by design, payments end when the transferor dies and the entire value of the asset sold is immediately removed from the transferor's gross estate. In other words, there is no estate tax in the transferor's estate from the transferred property - because it belongs to the buyer from the moment the private annuity document is signed.

Another advantage is that the private annuity allows someone who owns non-income-producing property to make that property productive.

The ideal transferor/payor situation is one that meets the following criteria:

  1. The transferor is in a high estate tax bracket or has no marital deduction.

  2. The property is capable of producing at least some income and/or is appreciating rapidly.

  3. The payor is capable of - at least in part - paying the promised amounts.

  4. The parties trust each other (the private annuity must be unsecured).

  5. The transferor has other assets and sources of income.

  6. The transferor has less than a normal life expectancy. (This makes the arrangement more of a "bargain" for the buyer)






Tools of Estate Planning

Annuity, Life Estate and Remainder Factors


Annuity Factors
For income, estate, or gift tax planning purposes, or for general financial planning purposes, it is often necessary to know the present value of a continuing series of payments to be received in the future. When the payments are regular and fixed in amount, they can be valued as an annuity.

The two simplest forms of annuities are annuities payable for a term of years and annuities payable for a life (or lives). There are also many possible variations, such as annuities payable for the shorter of a term or life, annuities with a guaranteed term (i.e., payable for the longer of a term or life), annuities that terminate upon the first death among several lives (instead of last-to-die), and deferred annuities that start at a future date. This program calculates only annuities for a term, for a life (or up to three joint lives), or the shorter of a term or life (or lives).

The present value of an annuity is usually determined by multiplying the total annual payments by a factor. When the annuity is payable annually and at the end of each year, the factor is nothing but the comparable life estate factor (see the Life Estate and Remainders Factors explanation below), divided by the assumed discount rate (i.e., the section 7520 rate). When annuities are payable semi-annually, quarterly, or monthly, or at the beginning of each payment period instead of at the end, the base factor must be adjusted.

The factors calculated by this program are based on rules and regulations under Section 7520 of the Internal Revenue Code, and methods used by the IRS consistent with those rules and regulations. This means that future values are discounted to present values using the interest rate required under Section 7520 (120% of the federal mid-term rate for the month, rounded to the nearest 2/10ths of a percent) and using Table 80CNSMT, Table 90CM, or Table 2000CM mortality values.

Life Estate and Remainder Factors
A term of years is the right to use, possess, and enjoy the property or the income it produces for a specified number of years. That right continues until the term expires (regardless of whether or not the person enjoying the property or the income it produces during that term continues to live. If the "term tenant" dies, the right can be left by will or passed to a family member through intestacy laws).

A life estate is the right to use, possess, and enjoy property or the income it produces for the life of a specified person. That measuring life (using age nearest birthday) can be the life of the holder of the interest or may be measured by the life of some other person (a so called "estate per autre vie").

A life estate can be payable for more than one life. For example, the right to live on or enjoy the income from property (in or out of trust) can extend for joint lives of you and your spouse or you and any other person or persons. Note that the life income beneficiary receives no right to enjoy the principal and the life estate therefore ends at the death of the "measuring life." But if one person holds a life estate (e.g. a parent) and another person is used as the measuring life (e.g., a child), the holder of the estate could give it away, sell it, or leave it in his or her will and it will continue in the new owner's hands - until the death of the measuring life.

A remainder interest is the right to use, possess, or enjoy property when the prior interest (term or life) ends. Mathematically, the value of a remainder interest is found by subtracting the present value of the prior interest from the entire fair market value of the property.

Terms of years, life estates, and remainder interests are key estate planning concepts. To make these time value of money computations, you must use a discount rate issued monthly by the federal government called the "Section 7520 rate." This is computed from the average market yield of U.S. obligations.






Tools of Estate Planning

Simplified GSTT Worksheet


GSTT, the Generation Skipping Transfer Tax, is a flat tax at the highest estate tax rate that is imposed in addition to any applicable gift or estate tax on any transfer of property made during a person's lifetime or at the time of their death to a donee considered a "skip" person, typically a grandchild or great grandchild. Whenever significant amounts of property are distributed to a beneficiary who is two or more generations younger than the transferor, the amount distributed may be subject to the GSTT.

Currently, if the amount of property transferred to a grandchild exceeds the GST exemption (the exempt amount each person is allowed to make during their lifetime or at the time of their death), the GST tax must be considered.

Gifts of less than the gift tax annual exclusion ($14,000 beginning in 2013, or $28,000 for spouses who gift-split) may be excludible from this calculation. Certain other transfers may also be exempt. These include:

  1. Tuition paid to an educational institution that meets the IRS income tax eligibility guidelines for deductible contributions.

  2. Payments made to a medical care provider by the transferor for such care.


The GSTT exemption (indexed for inflation in future years) is granted to every US citizen and can be used to shelter smaller estates. Once the exemption is allocated, it is irrevocable.

The GSTT is applied to three types of generation skipping transfers:

  1. Direct Skips - Essentially, an outright transfer that is subject to estate or gift taxes made to a grandchild

  2. Taxable Termination - This is a transfer to a grandchild that occurs when and because a trust beneficiary's interest ends. For example, a taxable termination occurs when the assets of a trust, created by a grandparent, are paid to a grandchild at the death of her parent who had been receiving income from the trust for life.

  3. Taxable Distributions - In essence any distribution other than a Direct Skip or a Taxable Termination made to a grandchild.


This calculation provides a simplified GSTT (Generation-Skipping Transfer Tax) calculation that will be applied to the transfer of any property where the tax is paid from other property (Direct Skip Transfers).

The GSTT rate is the maximum estate tax rate, which was 55% through 2001, 50% in 2002, 49% in 2003, 48% in 2004, 47% in 2005, 46% in 2006, 45% for 2007 through 2009, and 35% for 2011 and 2012, and 45% after 2012.


The GST exemption was $1,000,000 and indexed for inflation between 1997 and 2003 ($1,010,000 in 1999, $1,030,000 in 2000, $1,060,000 in 2001, $1,100,000 for 2002, and $1,120,000 in 2003). Under the Economic Growth and Tax Relief Reconciliation Act of 2001, the exemption was $1,500,000 in 2004 and 2005, $2,000,000 in 2007 through 2008, and $3,500,000 in 2009. Under the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010, GST tranfers in 2010 had an inclusion ration of zero. The GST exemption is the same as the estate tax exclusion amount after 2010
.





Tools of Estate Planning

Total Cost of GST Transfer


The GST has been used primarily as a method to keep property out of the taxable estates of the immediate generation of a family. The beneficiary would be permitted to have control of the income, use the principal as needed, and control distribution of the property as long as the beneficiary does not have a general power of appointment.

This calculation determines the actual total dollar amount (or real cost) needed to transfer a "target amount" through to a grandchild when the generation skipping transfer tax is involved.

The GSTT rate is the maximum estate tax rate, which was 55% through 2001, 50% in 2002, 49% in 2003, 48% in 2004, 47% in 2005, 46% in 2006, and 45% for 2007 through 2009, and 35% for 2011 and 2012. Under the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010, and all changes made by that act and the Economic Growth and Tax Relief Reconciliation Act of 2001will “sunset” in 2013, returning the top estate tax rate to 55%.

There are four different ways in which the GST can apply:

1. Lifetime Direct Skip - A lifetime gift to a grandchild or other "skip person." There is GST tax on the net amount passing to the grandchild, as well as gift tax on the net amount and the GST tax itself. When a tax is on the net amount after tax, it is said to be "tax exclusive."

2. Testamentary Direct Gift - A gift at death to a grandchild or other "skip person." There is GST tax on the net amount passing to the grandchild, as well as estate tax on the total pre-tax amount needed to produce the net amount for the grandchild. When a tax is on the gross amount before tax, like the estate tax, it is said to be "tax inclusive."

3. Lifetime Taxable Termination or Distribution - A lifetime gift to a trust which later terminates (or is distributed) to a grandchild or other "skip person." There is gift tax on the transfer to the trust, and then the GST tax on the total amount in the trust (tax inclusive).

4. Testamentary Taxable Termination or Distribution - A gift at death to a trust which later terminates (or is distributed) to a grandchild or other "skip person." There is estate tax on the gross amount, and then the GST tax on the total amount in the trust (tax inclusive).






Tools of Estate Planning

Section 529 (Qualified Tuition Programs)


A useful tax planning option for educational gifts to minors is the “qualified state tuition program" defined by section 529 of the Internal Revenue Code. The program must be created by a state (or state agency) and allow contributions to a tuition fund for a designated beneficiary, invest the contributions, and maintain separate accounts for each beneficiary. The tax advantages include the following:

  1. Contributions qualify for the federal gift tax annual exclusion and are no longer part of the donor's taxable estate. (And, if the contributions exceed the annual gift tax exclusion, the donor can elect to treat the gift as having been made in equal installments over 5 years, allowing the donor to use future exclusions immediately.)

  2. Neither the donor nor the beneficiary realizes any taxable income while the contributions are invested.

  3. The beneficiary realizes taxable income only when distributions are made or tuition is paid from the program but only (a) to the extent that the distributions (or tuition payments) exceed "qualified higher education expenses" (see below) and (b) in proportion to the increases in the fund over the contributions.

  4. The undistributed fund is not part of the beneficiary's taxable estate but can be refunded to the original donor.



However, there are limitations to these programs:

  1. Neither the donor nor the beneficiary can direct any investments of the program.

  2. Contributions are limited to the amounts needed for "qualified higher education expenses," which are the tuition, fees, books, supplies, and equipment at an "eligible educational institution," and expenses of room and board can be included only under certain circumstances.

  3. Beneficiaries can be changed only to a new beneficiary within the same family.

  4. Refunds can result in penalties (usually 10% of the distribution).



Despite these limitations, the benefit of income tax deferral on the earnings of the fund can be very valuable, and the exclusion of income paid for "qualified higher education expenses" is even more valuable.






Tools of Estate Planning

Gift Loans


Under section 7872 of the Internal Revenue Code, a loan can result in an immediate gift if (a) the loan is for a fixed term (and not payable on demand), (b) the loan is a “below-market loan” because the interest rate is less than the applicable federal rate (defined by section 1274(d) of the Internal Revenue Code), and (c) the foregone interest (the difference between the rate of interest charged on the loan and the applicable federal rate) is in the nature of a gift.


For a gift loan, the amount of the gift is the difference between (a) the amount received by the borrower and (b) the present value of all future payments to be made, based on the applicable federal rate in effect at the time the loan is made.


For income tax purposes, each year's foregone interest is treated as received by the lender on the last day of the calendar year.


Given the amount of the loan, the term of the loan, the frequency of the payments (monthly, quarterly, semiannually, or annually), whether the loan is amortized, level principal, or interest-only, the interest rate for the loan, and the applicable federal rate, the future payments can be calculated, along with the present value of those payments, the amount of the gift, and the future amounts of foregone interest.


In an amortized loan, the payments are calculated so that the periodic payments of combined interest and principal are equal amounts over the term of the loan. The interest is always calculated on the principal balance owed, but the interest amount goes down (and the principal amount goes up) as the principal of the loan is paid. So, early in the loan, the payments will be mostly income with very little principal paid, while towards the end of the loan the payments will be mostly principal with very little interest payable on the declining loan balance.


In a level-principal loan, the principal payment is fixed as the amount needed to pay off the principal amount over the stated term, and if there is no “balloon” payment, then the principal portion of each loan payment will be the principal amount of the loan divided by the number of payments to be made. The interest portion of each payment is calculated on the principal balance remaining, so the interest amount goes down as the principal of the loan is paid. Because the principal portion of each payment is a fixed amount, and the interest portion goes down over the course of the loan, each loan payment will be different, and the payments will go down over the term of the loan.


In an interest-only loan, no principal is paid until the end of the term. Because the principal of the loan remains the same throughout the term, the interest payments also remain the same.


A compromise between an interest-only loan and an amortized or level-principal loan is a loan in which some principal is paid during the term and the balance is paid as a “balloon” at the end of the term. So, for example, the periodic payments on a loan can be calculated based on an amortization over 30 years even though the term of the loan is only 15 years, in which case the balance of the principal is payable as a lump sum “balloon” at the end of the 15 years. A level-principal loan can also be calculated with a principal-recovery period that is longer than the actual term of the loan, also resulting in a balloon payment at the end of the term.


The “annual percentage rate” or “APR” is a useful number to know in comparing the true costs of different kinds of loans, and the APR is not necessarily the same as the interest rate used to calculate the loan payments. If the payments are monthly, quarterly, or semiannual, the APR will not be the same as the interest rate that is entered for the note because payments that are more frequent than annual have the effect of compounding the interest rate, so the APR (or effective interest rate) is higher.


The present value of future loan payments is calculated by discounting the future payments back to present value by applying the applicable federal rate.


The foregone interest is the difference between the interest actually payable under the loan and the interest that would have been payable using the applicable federal rate.






Trusts

GRIT/Qualified Personal Residence Trust


You create an irrevocable trust. You direct the trustee to pay you the income from the trust for a specified number of years or allow you possession of the trust's property. When your interest terminates at the end of the years you've selected, the property in the trust is distributed to family members or the other individuals you have chosen. In some cases, the trust continues for their benefit.

When you put cash or assets into the trust, you made what is called a "future interest" gift. The value of that gift is the excess of the value of the property you transferred over the value of the interest you kept. The value of your retained interest is found by multiplying the principal by the present value of an annuity factor for the number of years the trust will run.

For example, assuming a 7.6% federal discount rate, if the trust will run for ten years and $100,000 is initially placed into the trust subject to a reversion, the value of the (nontaxable) interest retained by a 65-year-old would be $64,590.

The value of the (gift taxable) remainder interest would be the value of the capital placed into the trust ($100,000) minus the value of the nontaxable interested retained by the grantor ($64,590). Therefore, the taxable portion of the grantor retained income trust gift would be $35,410. This remainder interest, by definition, is a future interest gift and will not qualify for the annual exclusion. The donor will have to utilize all or part of the remaining unified credit (or if the credit is exhausted, pay the appropriate gift tax).

The advantage of the GRIT is that it is possible for you to transfer assets of significant value to family members but to incur little or no gift tax. In the example above, the cost of removing $100,000 from the gross estate (plus all appreciation from the date of the gift) is the use of $35,410 of your constantly growing unified credit.

The GRIT is a "grantor trust." This means all income, deductions, and credits are treated as if there was no trust and these items were attributable directly to you, the grantor.

The longer term you specify the larger the value of the interest you have retained--and the lower the value of the gift you have made. However, the longer the term of the trust, the greater the probability that your death will occur during the term of the trust, and the entire principal (date of death value) must be included in the estate of a grantor who dies during the term of the GRIT since he has retained an interest for a period which, in fact, did not end before his death. If any gift tax had been paid upon the establishment of the GRIT, it would reduce the estate tax otherwise payable. If the unified credit was used, upon death within the term, the unified credit used in making the gift will be restored to the estate (if the grantor's spouse consented to the gift, his or her credit will not be restored). So the trick is to select a term for the trust that you are likely to outlive.

Quite often, the estate's beneficiary (possibly through gifts you make) will purchase life insurance on your life. Then, if you should die during the term of the GRIT, the tax savings you tried to achieve will be met through the life insurance and there would be sufficient cash to pay any estate tax.

IRC Code §2702 has severely limited the use of GRITs. Non-family members can use GRITs for any type of asset for any term. Family members will find GRITs useful only when the property transferred is a personal residence or for certain tangible property.

The regulations under §2702 allow two different kinds of trusts to hold personal residences, a "personal residence trust" (PRT) and a "qualified personal residence trust" (QPRT). A PRT is very limited and inflexible, because it must not hold any assets other than the residence and must not allow the sale of the residence. A QPRT can hold limited amounts of cash for expenses or improvements to the residence, and can allow the residence to be sold (but not to the grantor or the grantor's spouse). However, if the residence is sold, or if the QPRT ceases to qualify as a QPRT for any other reason, either all of the trust property must be returned to the grantor or the QPRT must begin paying a "qualified annuity" to the grantor (much like a grantor-retained annuity trust, or GRAT).






Trusts

Grantor Retained Annuity Trust (GRAT)

A grantor retained annuity trust may be an effective means for a wealthy client who wants or needs to retain all or most of the income from a high-yielding and rapidly-appreciating property to transfer the property to a child or other person with minimal gift or estate tax. GRATs are particularly indicated where the client has one or more significant income-producing assets that he or she is willing to part with at some specified date in the future to save federal and state death taxes and probate costs, to obtain privacy on the transfer, and to protect the asset against the claims of creditors.


A GRAT is created by transferring one or more high-yield assets into an irrevocable trust and retaining the right to an annuity interest for a fixed term of years or for the shorter of fixed term or life. When the retention period ends, assets in the trust (including all appreciation) go to the named "remainder" beneficiary (ies). In some cases other interests, such as the right to have assets revert back to the transferor's estate in the event of the transferor's premature death, may be included.


GRATs provide a fixed annuity payment, usually expressed as a fixed percentage of the original value of the assets transferred in trust. For example, if $100,000 is placed in trust and the initial annuity payout rate is 6 percent, the trust would pay $6,000 each year, regardless of the value of the trust assets in subsequent years. If income earned on the trust assets is insufficient to cover the annuity amount, the payments will be made from principal. Therefore, the client-transferor is assured steady and consistent payments (at least until principal is exhausted).


All income and appreciation in excess of that required to pay the annuity accumulate for the benefit of the remainder beneficiary (ies). Consequently, it may be possible to transfer assets to the beneficiary (ies) when the trust terminates with values that far exceed their original values when transferred into the trust and, more importantly, that far exceed the gift tax value of the transferred assets.


The gift tax value of the transferred assets is determined at the time the trust is created and funded using the "subtraction method." The gift tax value is determined by subtracting the value of the annuity interest (and, in some cases, other retained interests, such as the right to have the assets revert back to the transferor's estate if he or she does not live the entire term of the trust) from the fair market value of the assets transferred in trust. How the annuity interest and any other retained interests are valued depends on who the remainder beneficiary (ies) is (are) and who retains the annuity and other interests relative to the transferor. There is a more restrictive and less appealing set of valuation rules when family members are beneficiaries and certain family members retain interests in the property both before and after the trust is created than when unrelated parties are involved.


When unrelated parties are involved, all interests are valued according to their actuarial present values using the valuation rules of IRC §7520. These rules mandate the use of a discount rate based on the 120% Applicable Federal Annual Midterm Rate for the month in which the trust is created and funded. The mortality factors from Table 80CNSMT, Table 90CM, or Table 2000CM are also used if the interests have a life contingency (i.e., the calculations are of type "Life" or "Shorter").


The 120% Applicable Federal Annual Midterm Rate changes monthly and is reported in the IRS's Cumulative Bulletin, in various tax services, and in various financial news publications such as The Wall Street Journal. (See Fed Interest Rates in the Money & Investing section, generally between the 18th and 23rd of the preceding month).


If family members are involved, the gift tax valuation rules of IRC §2702 may apply. Under these rules, certain types of retained interests, such as the right to have trust assets revert to the transferor's estate in the event of the transferor's premature death, may be valued at zero when computing the gift tax value of the transfer. As a general rule, every retained interest but a "qualified interest" is assigned a value of zero for gift tax valuation purposes. In the case of a GRAT, a qualified interest is the right to receive "fixed amounts" payable annually, more frequently (a fixed annuity), or a qualified remainder interest. That is, any non-contingent remainder interest if all other interests in the trust consist of qualified retained interests (qualified annuities).


The right to receive a "fixed amount" means the annuity must be a specified fixed dollar amount or a fixed percentage of the initial value of the trust payable each year rather than merely the income produced by the assets in the trust. Although fixed payments throughout the term of the trust are the norm, final regulations define the term "fixed amount" more liberally. They would permit the annuity payments to increase or decrease in a systematic manner each year without adverse gift tax consequences. However, the annuity amount may not increase by more than 20 percent over the prior year. For example, if the initial annuity payment is $1,000, the trust could provide that annuity payments in subsequent years increase by as much as 20 percent, to $1,200 in the second year, $1,440 the third year, and so on. If the transferor retains the right to the greater of a fixed amount or the trust income in each year for a term of years, the annuity will still be a qualified annuity. However, the right to the trust income, if any, in excess of the fixed amount is valued at zero for gift tax purposes. Thus, the retained interest is valued for gift tax purposes as if it did not include any rights to excess income.


We suggest you "insure" or "bulletproof" the tax savings. The risk of inclusion of trust assets should be covered by the purchase of life insurance owned by the appropriate beneficiary on your life in the amount of the anticipated federal estate taxes that would be saved if you survive the term of the trust.


Since the GRAT permits payment of both income and trust principal to satisfy the annuity payments you have retained, the GRAT should be treated as a grantor trust for income tax purposes. This means you (the transferor-annuitant) are taxed on income and realized gains on trust assets even if these amounts are greater than the trust's annuity payments. This further enhances this tool's effectiveness as a family wealth-shifting and estate-tax-saving device. In essence you are effectively allowed to make gift tax-free gifts of the income taxes that are really attributable to assets backing the remainder beneficiary's interest in the trust.


By making assumptions about income to be earned by the trust in the future, and future capital growth, it is also possible to project the future value of the principal remainder that will be payable to the beneficiaries at the end of the term of the trust. If limited partnership interests, minority stock interests, or other fractional or non-controlling interests have been contributed to the GRAT and appropriate discounts claimed for lack of voting power or lack of marketability, it may also be useful to illustrate the future economic growth of the pre-discounted value of the principal, and to compare the present value of the remainder for gift tax purposes (including appropriate discounts) with the projected future value of the principal remainder (without discounts).





Trusts

Grantor Retained Unitrust (GRUT)


A grantor retained unitrust may be an effective means for a wealthy client who wants or needs to retain all or most of the income from a high-yielding and rapidly appreciating property to transfer the property to a child or other person with minimal gift or estate tax. GRUTs are particularly indicated where the client has one or more significant income-producing assets that he or she is willing to part with at some date in the future to save federal and state death taxes, probate costs, to obtain privacy on the transfer, and to protect the asset against the claims of creditors.

A GRUT is created by transferring one or more high-yield assets into an irrevocable trust and retaining the right to an annuity interest for a fixed term of years or for the shorter of fixed term or life. When the retention period ends, assets in the trust (including all appreciation) go to the named "remainder" beneficiary (ies). In some cases other interests, such as the right to have the assets revert back to the transferor's estate in the event of the transferor's premature death, may be included.

GRUTs provide an annuity payment equal to a fixed percentage of the current value each year of the assets in trust. In this sense, a GRUT is similar to a variable annuity. The payout rate is fixed, but since the value of the assets can be expected to vary year to year, the dollar annuity payout also varies year to year.

For example, if $100,000 is placed in trust and the annuity payout rate is 5 percent, the trust would pay $5,000 the first year. If the value of the assets in trust increase to $110,000 in the subsequent year, the payout would be $5,200, 5 percent of $110,000. If income earned on the trust assets is insufficient to cover the annuity amount, the shortfall in payments will be made from principal. All income and appreciation in excess of that required to pay the annuity accumulate for the benefit of the remainder beneficiary (ies). Consequently, it may be possible to transfer assets to the beneficiary (ies) when the trust terminates with values that far exceed their original values when transferred into the trust and, more importantly, that far exceed the gift tax value of the transferred assets.

The gift tax value of the transferred assets is determined at the time the trust is created and funded using the "subtraction method." The gift tax value is determined by subtracting the value of the annuity interest (and, in some cases, other retained interests, such as the right to have the assets revert back to the transferor's estate if he or she does not live the entire term of the trust) from the fair market value of the assets transferred in trust. How the annuity interest and any other retained interests are valued depends on who the remainder beneficiary (ies) is (are) and who retains the annuity and other interests relative to the transferor. There is a more restrictive and less appealing set of valuation rules when family members are beneficiaries and certain family members retain interests in the property both before and after the trust is created than when unrelated parties are involved.

When unrelated parties are involved, all interests are valued according to their actuarial present values using the valuation rules of IRC §7520. These rules mandate the use of a discount rate based on the 120% Applicable Federal Annual Midterm Rate for the month in which the trust is created and funded. The mortality factors from Table 80CNSMT, Table 90CM, or Table 2000CM are also used if the interests have a life contingency (i.e., the calculations are of type "Life" or "Shorter").

The 120% Applicable Federal Annual Midterm Rate changes monthly and is reported in the IRS's Cumulative Bulletin, in various tax services, and in various financial news publications such as The Wall Street Journal. (See Fed Interest Rates in the Money & Investing section, generally between the 18th and 23rd of the preceding month).

If family members are involved, the gift tax valuation rules of IRC §2702 may apply. Under these rules, certain types of retained interests, such as the right to have trust assets revert to the transferor's estate in the event of the transferor's premature death, may be valued at zero when computing the gift tax value of the transfer. As a general rule, every retained interest but a "qualified interest" is assigned a value of zero for gift tax valuation purposes. In the case of a GRUT, a qualified interest is the right to receive (1) amounts that are payable annually or more frequently and are a "fixed percentage" (annuity payout rate) of the fair market value of the property in the trust (as revalued annually) or (2) a qualified remainder interest, that is, any non-contingent remainder interest if all other interests in the trust consist of qualified retained interests (qualified annuities).

The annuity must be a fixed percentage of the fair market value of the trust assets as revalued each year rather than merely the income produced by the assets in the trust. Although payments equal to an unchanging "fixed percentage" of the trust assets is the norm, final regulations define the term "fixed percentage" more liberally. They would permit the annuity payout rate to increase or decrease in a systematic manner each year without adverse gift tax consequences. However, the annuity payout rate in any year may not be more than 120 percent of the prior year's payout rate.

For example, the trust could provide that the annuity payout rate in each subsequent year would equal 120 percent of the prior year's rate. If the initial annuity payout rate is 5%, it could increase to 6% in the second year, 7.2% in the third year, and so on. If the transferor retains the right each year to the greater of a fixed percentage of the value of trust assets as revalued annually or the trust income for a term of years, the annuity will still be a qualified annuity. However, the right to the trust income, if any, in excess of the fixed percentage of trust assets is valued at zero for gift tax purposes. Thus, the retained interest is valued for gift tax purposes as if it did not include any rights to excess income.

Finally, under the §2702 rules, the retained annuity interests value cannot exceed the actuarial value of an annuity for the shorter of the specified term or life, even if the trust instrument itself calls for payment of a term-certain annuity.

These more restrictive rules apply if the transfer is to or for the benefit of a "member of the transferor's family" and an interest in the trust is "retained" by the transferor or an "applicable family member." A member of the transferor's family includes the transferor's spouse, ancestor, lineal descendent, an ancestor or lineal descendent of the spouse of the transferor, a brother or sister, and the spouse of any of these. A retained interest means a property interest held by the same individual both before and after the transfer in trust. An applicable family member is defined as the transferor's spouse, an ancestor of the transferor or an ancestor of the transferor's spouse, and the spouse of any such ancestor.

In summary, if the §2702 rules apply, the annuity must be for a fixed percentage of the value of the trust assets as revalued each year for a specified term. The annuity will be considered for a qualified "fixed percentage" if the scheduled payout rate in any year does not exceed 120 percent of the prior year's payout rate. The specified term may be the life of the annuitant, a fixed term, or the shorter of a fixed term or the life of the annuitant.

Regardless of the specified term, the annuity is valued for gift tax purposes as if it were for the shorter of a fixed term or the life of the annuitant. In other words, although the terms of the trust may specify that the annuity is to be paid for fixed and certain term of years, regardless of the survival of the annuitant, it must be valued for gift tax purposes as if it terminates upon the annuitant's death. Any other retained interest (other than a retention of a qualified remainder interest), including any rights to income or to a reversion of trust assets in the event of premature death, are valued at zero for gift tax purposes. Therefore, the gift tax value of the transfer is determined by subtracting the actuarial value of the qualified life-contingent unitrust annuity from the fair market value of the trust assets at the time the trust is created and funded.

If the transferor-annuitant survives the term of the GRUT, the assets transferred in trust are not included in the transferor's gross estate and escape estate taxation. Although there is no statutory or regulatory authority on the issue, some experts think the maximum amount the IRS could include is the lesser of the entire trust corpus or the amount of corpus required to provide the promised unitrust amount for the term (without invading principal).

This amount is computed by dividing the adjusted unitrust payout rate, for example, 5%, by the §7520 rate for the month of the transferor-annuitant's death, say 7.6%, to derive the proportion of the trust's corpus that is includable for estate tax purposes, in this instance, 65.79 percent. A logical but more aggressive and uncertain argument can be made that the amount included should not exceed the present value of the expected unitrust annuity payments at the scheduled adjusted payout rate over the remaining term of the trust assuming the assets are invested at the §7520 rate. For example, if 3 years remain in the term of the trust, the present value of a unitrust annuity interest with a 5% adjusted payout rate is only 0.142625. In other words, only 14.2625 percent of the trust assets are actually economically required to fund the unitrust annuity payments over the remaining 3-year term. In any event, the risk of inclusion of trust assets should be covered by the purchase of life insurance owned on the transferor's life by the appropriate beneficiary.

Since the GRUT permits payment of both income and trust principal to satisfy the transferor-annuitant's unitrust annuity payments, the GRUT should be treated as a grantor trust for income tax purposes. This means the transferor-annuitant is taxed on income and realized gains on trust assets even if these amounts are greater than the trust's unitrust annuity payments. This further enhances this tool's effectiveness as a family wealth-shifting and estate-tax-saving device. The transferor-annuitant is effectively allowed to make gift-tax free gifts of the income taxes that are attributable to assets backing the remainder beneficiary's interest in the trust.






Trusts

IDIT Installment Sales


Like a grantor retained annuity trust (GRAT), an installment sale to an income trust may be an effective means for a wealthy client to transfer part of the future income or appreciation from a high-income or rapidly-appreciating asset with little or no gift or estate tax cost.

An "income trust" is a trust of which the grantor is considered the owner for federal income tax purposes. This means that the grantor must report, on the grantor's individual income tax return, all of the income, deductions, and credits of the trust, just as if the grantor was the owner of the trust grantor assets. The IRS has also ruled that a sale or other transactions between an income trust and the grantor does not result in any capital gain or loss, or any other tax consequences. The trust is ignored for federal income tax purposes and the grantor is still the owner.






Trusts

Dynasty Trust


This calculation illustrates the wealth transfer power of combining several tax techniques into a single trust, here called a "defective dynasty trust."

"Defective" Trust
A "defective" trust is a trust in which the grantor (or in certain cases, the beneficiary) is treated as the "owner" of the trust for income tax purposes, but not for estate, gift, or generation-skipping transfer tax purposes. This means that the grantor is taxed on the trust income and gets the benefit of all the deductions and credits attributable to the trust. IRC Section 671. Many practitioners believe that one of the benefits of a trust in which the grantor pays the income tax is that the payment of the tax is the equivalent of a tax-free gift to the trust to the extent no reimbursement is made (unless the trust instrument or state law requires reimbursement to the grantor from the trust). This benefit is important if the trust is purchasing life insurance because the trust can grow free of income tax and be able to pay larger premiums.

The Leverage of Market Discounts
Another technique used by many practitioners is the intra-family transfer of closely held business interests, family limited partnerships, and other types of fractional or minority interests for which the fair market value (determined by reference to a hypothetical willing buyer and willing seller in accordance with Treasury regulations and court rulings) will be less than the proportionate value of the underlying assets owned by the corporation or partnership, due to discounts for lack of control and lack of marketability. By selling a discounted minority interest to a defective trust, the grantor can increase the "leverage" of the sale, providing additional value to the beneficiaries without gift tax.

Sale to a "Defective" Trust - How the Technique Works
The first step is for the grantor to make a gift to the trust as initial "seed money" or equity so that the trust is not under-capitalized and the transaction is a real sale and not a "sham." (If the sale is too highly leveraged, the seller is totally dependent on the asset itself for the payment of the purchase price, would could lead the IRS and the courts to conclude that the transaction was not really a sale at all.) The grantor subsequently sells interests in a limited partnership (or other entity) to the trust in exchange for an interest-only promissory note with a balloon payment at the end of the term. The sale is income tax free because the trust is "defective" for income tax purposes. (See Rev. Rul. 85-13.) The interest rate for the sale is a market rate of interest determined under IRC Section 1274(d). Because the minority interest transferred represents a discounted value from the proportionate share of the business or assets owned by the partnership or other entity, the income from the minority interests should be higher than the income from other assets with the same fair market value. If the trust is "defective" and does not pay income tax, the income will be able to accumulate more rapidly. The difference between the trust income and the interest on the promissory note may therefore accumulate tax-free for the beneficiaries of the "defective" trust.

Why Use a Dynasty Trust
A dynasty trust is an irrevocable trust drafted to last for multiple generations without any estate, gift or generation-skipping transfer taxes at the death of the grantor's children and in some cases without any such taxes at the death of lower generations as well. Unlike most trusts that require distributions to be made to the children at certain ages, the dynasty trust instead gives the children and other descendants the use and control over the trust property as trustee upon reaching the age at which most standard trusts would otherwise distribute the trust property to the beneficiaries free of trust. This gives the beneficiaries control over and enjoyment from the trust assets as if they owned the property outright, but without causing inclusion in their taxable estates and without subjecting their property to their personal creditors, including ex-spouses.

The federal estate tax applies to the net estate of a decedent at death, and federal estate tax rates have been as high as 55% for estates of $3,000,000 or more, with an additional 5% payable (or a total of 60%) for estates between $10,000,000 and $17,184,000 but are scheduled to decline to 50% in 2002 and by 1% annual decrements to 45% in 2007, and the estate tax is supposed to be repealed in 2010. In order to prevent the avoidance of the estate tax through long-term trusts, Congress also imposed a generation-skipping transfer tax equal to the maximum federal estate tax rate on each generation-skipping transfer, payable from a generation-skipping trust at the death of each generation. However, there is a generation-skipping tax exemption for each person, and it is possible to "leverage" that exemption through life insurance, so that a multi-generation dynasty trust can be created that can benefit each generation free of federal estate tax and generation-skipping tax.

A major limitation on multi-generational dynasty trusts is the traditional "rule against perpetuities," which states that each trust must "vest" (or terminate for tax purposes) twenty-one years after the deaths of all lives in being when the trust was created. That means that a trust can always last at least until all of the grandchildren are twenty-one, and careful drafting can usually allow a trust to last 100 years or more without violating the rule against perpetuities.

Perpetual Trusts
The choice of state law to apply to the dynasty trust is a decision that can affect the wealth of the grantor's descendants for many generations. Several states (twelve as of 6/1/00) have repealed or modified the common law "rule against perpetuities" to allow trusts to continue forever without any additional gift, estate or generation-skipping transfer taxes. (In the states which still apply the rule against perpetuities, the trust must usually terminate and distribute the trust assets twenty-one years after the grantor and others living when the trust was created have died. Once the trust has terminated, the assets become subject to estate and gifts taxes again.) By extending the term of the trust, the grantor can delay (or avoid altogether) the imposition of any estate tax on the principal and accumulated income of the trust.

Choosing a State Situs
In order to get the benefit of the favorable trust and tax laws of South Dakota, Delaware, or other states, it is usually necessary to have at least one trustee residing in that state. To provide continuity of management, and insure that the resident trust will not die or move, it may advisable to use a bank or trust company as a trustee. (One or more beneficiaries may also be co-trustees and may be given the power to remove and replace the corporate trustee without adverse income, estate, or gift tax consequences. It is also possible for the grantor to retain this power under the holding of Rev. Rul. 95-58.)

Why this Technique is Invaluable as a Life Insurance Tool
Estate taxes are due within nine months of the death of a single individual or the second to die of a married couple. In almost all cases, life insurance is used to provide the liquidity to pay the taxes without having to sell the estate assets at low values. Life insurance proceeds are income tax free (subject to exceptions), but not estate tax free. In order to make it estate tax free, the life insurance should be purchased by an irrevocable life insurance trust. Most life insurance trusts are structured as Crummey trusts (named after the case by that name) so that transfers to the trust qualify for the gift tax annual exclusion. For larger estates, however, there often aren't enough Crummey beneficiaries to pay the premiums without making taxable gifts. This often results in the client not purchasing enough insurance to fund the estate tax (or other obligation). Since the sale to a "defective" trust can create such a large cash flow, significant insurance premiums can be supported by the trust assets. In addition, the "defective" trust can also be used to purchase an existing policy from either the insured or an existing life insurance trust without violating the transfer for value rules (IRC Section 101(a)(2)) and without causing estate inclusion under the three-year rule (IRC Section 2035).

In almost all but the largest estates, the installment sale technique will provide sufficient cash flow to purchase more insurance than the client needs. This is because the technique leverages the estate, gift and generation-skipping transfer taxes so much. If this result is higher than necessary, then the options are to either gift and sell less to the dynasty trust or to use part of the trust income for life insurance and part for other investments.

These dynasty trust calculations and explanations are based on concepts and illustrations created by attorney Steven J. Oshins, Las Vegas, Nevada, and are reproduced here with his permission.






Trusts

Split Interest - Life


In a "split interest" purchase arrangement, an asset is purchased by one party who acquires a life income interest in the asset while the other party acquires a remainder interest. Each party pays his or her proportionate share of the cost based on the IRS tables that state the actuarial value of a life estate and remainder interest at various ages.

An uncle and niece, for example, might agree to acquire land that they feel will appreciate. Assume the land has a value of $100,000. If the uncle is 55 years of age, assuming a Section 7520 rate of 12 percent, his life income interest is worth 86.0 51% ($86,051) of the full value of the property. He will pay that amount toward the split purchase. His niece will contribute the balance of $13,949 as her share of the $100,000 purchase.

If the arrangement is structured properly, the uncle (life tenant) will receive the right to possess the property in question or enjoy any income it produces for as long as he lives. In many cases, this means the life tenant will enjoy more income than he would have received had he invested the amount of his contribution to acquire the same type of asset.

In the example above, the uncle invests $86,051, but if the $100,000 property produces a ten- percent return, he will receive $10,000 a year, which is considerably more than if he had received ten percent of $86,051. Should the income produced by the split purchased asset increase, so will the life tenant's income. If the life tenant outlives the actuarial life expectancy built into the IRS assumptions, he will continue to enjoy the property (or to receive the income it produces). The life tenant is taxed on any income received (unless the asset is a tax-exempt bond, or is otherwise exempt from tax).

If (and only if) the parties to the SPLIT are unrelated, or are beyond the Internal Revenue Code definition of "applicable family members", a number of significant estate tax objectives may be accomplished by the split interest purchase:

  1. First, assuming the property is fairly valued (at least one independent and highly qualified and diligent appraiser is suggested), there should be no gift tax on the creation of the interest if the government's tables are used to determine the actuarial contributions of each party.

  2. Second, since the life estate terminates upon the death of the life tenant, there can be no transfer by that individual. Absent a transfer, nothing is subject to the federal estate tax.

  3. Furthermore, the underlying asset is at that time owned by the remainder person and cannot be part of the probate estate. Therefore, the uncertainty, delay, and cost of probate are eliminated.


If the underlying asset appreciates in value between the time of acquisition and the life tenant's death, any appreciation will also be excluded from the life income owner's estate.

The remainder interest holder receives no advantage during the life tenant's life. The remainderman derives his or her sole benefit upon the death of the life income owner (except for the significant advantage of knowing that no one else can receive the property at the life tenant's death.)

No increase in basis is allowed to the remainderman at the life tenant's death. This is because nothing is in the life tenant's estate and, therefore no part of the property receives a "step up in basis." The remainderman's basis is the cost of his remainder interest. Therefore, upon the sale of the property after the death of the life tenant, the remainderman realizes a gain. That gain is equal to the difference between his basis (the amount paid when the property was purchased) and the amount realized by the remainderman upon the sale.

There are downsides and risks to the split interest purchase. First, if it is between family members, there will be immediate gift tax implications. Second, the IRS may question whether the remainder person did in fact furnish consideration for the acquisition of the remainder interest. Obviously, if a source of income other than the life tenant can be shown, or if that individual has resources of his own with which to make the acquisition and he or she is an adult, the likelihood of IRS success is reduced considerably.

Conversely, if the client provides financing to the remainder person, the IRS could view the transaction as one in which the uncle acquired an interest in the entire property and then made a gift of the remainder interest with the retention of life income. This will result in estate tax inclusion.

Each party should pay the actuarial value of his or her interest, the property should be purchased independently and simultaneously from an unrelated third party who fixed the value of property, and the life tenant's control, rights, and duties should be consistent with those of a life tenant.

To the extent the remainderman does not furnish consideration for the acquisition of his or her interest, the IRS will attempt to show that a gift has been made from the life tenant to that remainderman. Since this would be considered a gift of a "future interest," the annual gift tax exclusion would not be allowable on the gift. Therefore, there would be adverse income, gift and estate tax implications.

Counsel should draw this split interest purchase so it will be recognized under local law as a combination of life tenancy and remainder interest. Title to the asset should be taken in a manner that reflects the appropriate division.






Trusts

Bypass Trust Computation


calculation computes the estate tax saving that is possible when the unified credits of both husband and wife are used to reduce the estate tax otherwise payable when they have both died.

The federal estate tax applies to the net estate of a decedent at death, but each person is allowed a unified credit which provides an exclusion from tax. For example, the unified credit applicable exclusion amount is $5,250,000 for 2013. For gifts and estates that exceed that amount, the tax rate is 40%.

An effective estate planning technique to use both unified credits is to change the wills or revocable trusts of the married couple so that, on the first death, the unified credit exclusion amount does not pass to the surviving spouse but is held in a trust for the benefit of the surviving spouse. In this way, the surviving spouse can get the income and benefit of the property held in the trust without the property being part of the survivor's estate. Upon the death of the surviving spouse, the property in the trust passes to (or in further trust for) the children or other intended beneficiaries free of tax. This kind of trust is sometimes called a "bypass" trust, because the property in it "bypasses" the estate of the surviving spouse.

The program illustrates the benefit of the bypass trust by calculating the federal and state death taxes that would be payable at the second death if the first spouse to die were to leave his or her entire estate to the survivor, so that the combined assets of the husband and wife were all taxable at the death of the survivor, and calculating the federal and state death taxes that would be payable at the second death if, at the first death, an amount equal to the unified credit applicable exclusion amount were removed from the taxable estates through a bypass trust. The difference in tax is the savings from the bypass trust.

The estate tax calculations take into account the changes in rates and credits provided by the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010, including the "deceased spousal unused exclusion amount" (DSUEA) that the surviving spouse may receive after the first death and which is intended to allow the estate of the surviving spouse to claim the benefit of the unified credits of both spouses without the use of a bypass trust. The bypass trust may still result in lower taxes at the second death due to (a) growth in the value of assets after the first death which can be excluded from the estate of the surviving spouse through the bypass trust but not through the use of the DSUEA, and (b) the possible reduction in the DSUEA by adjusted taxable gifts on which gift tax was paid.

In order to create the largest possible bypass trust at the first death, and so get the greatest benefit from the decedent's unified credit, there must be assets in the decedent's estate (or revocable trust) sufficient to use up all of the decedent's unified credit. Assets that are jointly owned will pass outside of the will or revocable trust and cannot be used to fund the bypass trust. Life insurance or retirement benefits payable to a named beneficiary will also pass outside of the will or revocable trust (and outside of the bypass trust). And if one spouse has a large estate and the other a small estate (or no separate estate at all), the benefit of the unified credit can be lost if the spouse with the smaller estate dies first. Finally, some assets may not be suitable for a bypass trust. For example, death benefits from a qualified plan or individual retirement account can be rolled over by a surviving spouse, and the income tax deferred on those benefits, but the income tax might have to be paid prematurely, with a greater income tax cost, if the benefits are payable to the bypass trust. Therefore, although the program assumes that a bypass trust can be fully funded at the first death, careful planning may be needed to be certain that there are in fact appropriate assets in the estate to fund the bypass trust at the first death.

If there is still estate tax payable when both unified credits have been used, a common next planning step is to look into removing life insurance from the taxable estates, or purchasing additional life insurance to provide the cash needed to pay the death taxes at the second death.






Trusts

Contingent Reversions


The grantor of a trust (or other similar beneficial interests in property) will sometimes retain the right to receive back the property in the trust if all of the beneficiaries should die and the grantor is still living. The possibility of that kind of “contingent reversion” would exist if, for example, the grantor has given property in trust for the benefit of a child and directed that the trust distribute income to the child for life and then distribute the trust property to the child's children (the grantor's grandchildren) when the child dies, and the grantor has directed that the trust property return to the grantor if the child dies without any grandchildren surviving her and the grantor is still living, but that the trust property go to the grantor's intestate heirs if the grantor is not then living.


A contingent reversion can have federal estate tax or federal income tax consequences if the present value of the contingent reversion is more than 5% of the value of the trust.


Under section 2037(a) of the Internal Revenue Code, the entire value of a trust is included in the grantor's gross estate for federal estate tax purposes if (1) possession or enjoyment of the trust property is contingent on surviving the grantor, and (2) the value of the grantor's possible reversionary interest is more than 5 percent of the value of the trust immediately before the grantor's death.


Under section 673(a) of the Internal Revenue Code, the grantor of a trust is treated as the owner of any portion of the income or principal of a trust (which means that the income from that portion of the trust is taxed to the grantor and not the trust) in which the grantor has a reversionary interest with a value of more than 5 percent of the value of that portion of the trust.


This module calculates the present value of a contingent reversion (the present value being a percentage of the value of the trust or the relevant portion of the trust), given the age of the grantor, the ages of up to five beneficiaries who must die before the grantor receives the reversion, and the discount rate under section 7520 of the Internal Revenue Code (which is 120% of the applicable federal mid-term rate, rounded to the nearest two-tenths of a percent). The reversion is calculated in the same way as a remainder following a simple income interest, without regard to any possible principal distributions or any income accumulations.






Charitable

Charitable Remainder Annuity Trust (CRAT)


This calculation determines the value of the noncharitable beneficiary's annuity (nondeductible) and the value of the charitable remainder interest (deductible) for a gift made through a charitable remainder annuity trust.

When a charitable remainder annuity trust is established, a gift of cash or property is made to an irrevocable trust. The donor (and/or another noncharitable beneficiary) retains an annuity (fixed payments of principal and interest) from the trust for a specified number of years or for the life or lives of the noncharitable beneficiaries. At the end of the term, the qualified charity specified in the trust document receives the property in the trust and any appreciation.

Most gifts made to a charitable remainder annuity trust qualify for income and gift tax charitable deductions (or in some cases an estate tax charitable deduction). A charitable deduction is permitted for the remainder interest gift only if the trust meets certain criteria.

A trust qualifies as a charitable remainder annuity trust if the following conditions are met:

  1. The trust pays a specified annuity to at least one non-charitable beneficiary who is living when the trust is created. Annuities can be paid annually, semiannually, quarterly, monthly, or weekly.

  2. The amount paid, as an annuity, must be at least 5%, but less than 50% of the initial net fair market value of the property placed in the trust. The charity's interest at inception also must be worth at least 10 percent of the value transferred to the trust.

  3. The annuity is payable each year for a specified number of years (no more than 20) or for the life or lives of the noncharitable beneficiaries.

  4. No annuity is paid to anyone other than the specified noncharitable beneficiary and a qualified charitable organization.

  5. When the specified term ends, the remainder interest is transferred to a qualified charity or is retained by the trust for the use of the qualified charity.

  6. The Internal Revenue Service has also ruled that a trust is not a charitable remainder annuity trust if there is a greater than 5% chance that the trust fund will be exhausted before the trust ends.

annuity paid must be a specified amount expressed in terms of a dollar amount (e.g., each non-charitable beneficiary receives $500 a month) a fraction, or a percentage of the initial fair market value of the property contributed to the trust (e.g., beneficiary receives 5% each year for the rest of his life).

The grantor will receive an income tax deduction for the present value of the remainder interest that will ultimately pass to the qualified charity. Government regulations determine this amount, which is essentially calculated by subtracting the present value of the annuity from the fair market value of the property and/or cash placed in the trust. The balance is the amount that the grantor can deduct when the grantor contributes the property to the trust.






Charitable

Charitable Remainder Unitrust (CRUT)


This calculation determines your deduction for a contribution to a charitable remainder unitrust. It also calculates your deduction as a percentage of the amount transferred.

When a charitable remainder unitrust is established, a donor transfers cash and/or property to an irrevocable trust but retains (either for himself or for one or more non-charitable beneficiaries) a variable annuity (payments that can vary in amount, but are a fixed percentage) from that trust. At the end of a specified term, or upon the death of the beneficiary (or beneficiaries, and the donor and the donor's spouse can be the beneficiaries), the remainder interest in the property passes to the charity the donor has specified.

The principal difference between a charitable remainder unitrust and a charitable remainder annuity trust is that a unitrust pays a varying annuity. In other words, the amount paid is likely to change each year. The payable amount is based on annual fluctuations in the value of the trust's property. As it goes up, so does the annuity paid each year. If it drops in value, so will the annuity.

A gift to a charitable remainder unitrust will qualify for income and gift tax charitable deductions (or an estate tax charitable deduction) only if the following conditions are met:

  1. A fixed percentage (not less than 5% nor more than 50%) of the net fair market value of the assets is paid to one or more non-charitable beneficiaries who are living when the unitrust is established. The charity's actuarial interest must be at least 10% of any assets transferred to the trust.

  2. The unitrust assets must be revalued each year, and the fixed percentage amount must be paid at least once a year for the term of the trust, which must be a fixed period of 20 years or less, or must be until the death of the noncharitable beneficiaries, all of whom must be living at the beginning of the trust.

  3. No sum can be paid except the fixed percentage during the term of the trust and at the end of the term of the trust, the entire balance of the trust's assets must be paid to one or more qualified charities.


The donor receives an immediate income tax deduction for the present value of the remainder interest that will pass to the charity at the end of the term.

Because a charitable remainder unitrust is exempt from federal income tax (the income and gains of the trust are only taxed when they are distributed to the noncharitable beneficiaries as part of the fixed percentage of trust assets distributed each year), they are frequently used to defer income tax on gains about to be realized. For example, if a donor has an appreciated asset that is about to be sold, the donor can give the asset to a charitable remainder unitrust, reserving the right to received a fixed percentage of the value of the trust for life, and for the life of the donor's spouse as well, and the asset can then be sold by the trust and the proceeds of sale reinvested without payment of any federal income tax on capital gains. The capital gains will be taxable to the donor (or the donor's spouse) only as they are distributed to the donor as part of the annual distributions from the trust.

A variation of the CRUT (which pays a fixed percentage of the value of the trust assets, regardless of income) is the net-income-with-makeup CRUT, or "NIMCRUT," which pays either the fixed percentage or the income actually received by the trust, whichever is less. However, if the income is less than the fixed percentage, the deficiency can be paid in a future year, as soon as the trust has income, which exceeds the fixed percentage. An additional variation is a "flip" unitrust, which is a trust that changes from a NIMCRUT to a regular CRUT upon the occurrence of a specific event, such as the sale of a specific asset that was contributed to the trust and was not expected to produce much income. However, both NIMCRUTs and "flip" CRUTs are valued in the same way as a regular CRUT for the purpose of determining the income, estate, and gift tax charitable deduction.






Charitable

Charitable Lead Annuity Trust (CLAT)


You create a CLAT by transferring cash or other assets to an irrevocable trust. A charity receives fixed annuity (principal and interest) payments from the trust for the number of years you specify. At the end of that term, assets in the trust are transferred to the non-charitable remainderperson (or persons) you specified when you set up the trust. Usually, this person is a child or grandchild but can be anyone, even someone who is not related to you.

You can set up a CLAT during your lifetime or at your death. Both corporations and individuals may establish lead trusts.

You can set up a CLAT so that you will receive an immediate and sizeable income tax deduction. In the second and following years, you must report the income earned by the trust even though it is actually paid to the charity in the form of an annuity.

What is the advantage of a trust that produces a high deduction in the first year but requires you to report income you don't receive in later years? One advantage is the acceleration of the deduction. For example, suppose you have just won the lottery, closed an incredibly large case, or sold a very highly appreciated asset. Perhaps you reasonably expect that in future years, your income will drop considerably. It's good planning to have a very high deduction in a high bracket year even if you have to report that income in lower bracket years. You are spreading out the income (and the tax) over many years.

Another advantage of the CLAT is that it allows a "discounted" gift to family members. Under present law, the value of a gift is determined at the time the gift is made. The family member remainderman must wait for the charity's term to expire; therefore, the value of that remainderman's interest is discounted for the "time cost" of waiting. In other words, the cost of making a gift is lowered because the value of the gift is decreased by the value of the annuity interest donated to charity.

When the assets in the trust are transferred to the remainderman, any appreciation on the value of the assets is free of either gift or estate taxation in your estate.

Many people of wealth set up CLATs at death through their wills. The present value of the charity's annuity stream is deductible for estate tax purposes. Since your heirs don't pay estate taxes on the charity's portion, the money that otherwise would have been paid in estate taxes can instead be invested. During the term of that trust, increased investment income can help pay for the fixed annuity promised to the charity - and if there is any "surplus", that extra income can be compounded for your heirs and pass to them - gift tax free - when the trust ends.






Charitable

Charitable Lead Unitrust (CLUT)


This calculation determines the value of the deduction for a transfer of cash or other property to a CLUT. It shows the future interest gift made to the non-charitable remainderman. It also shows the percentage of principal that is deductible for gift tax purposes.

When a term-of-years CLUT is established, a donor transfers cash or other assets to an irrevocable trust. A charity you select receives variable annuity payments from the trust for the term of years you have specified. That means each year the value of the trust's assets is re-determined. Although the charity will continue to receive the same percentage of the trust's assets each year, as the total value increases, the charity receives more. If the value of the trust's assets fall, the charity will receive less. For example, if the trust is worth $1,000,000 when you create it and you've given the charity a 6% annuity, it will receive $60,000 in the first year. If the trust doubles in value in the second year, the charity will still receive 6% - but of $2,000,000, i.e., $120,000. Of course, if the value of the trust in the third year falls to only $500,000, the charity receives 6% of $500,000, $30,000.

When the trust ends, assets in the trust will pass to the non-charitable remainderperson or persons you have specified. Although this party is usually a child or grandchild, it can be any person you select - including someone who is not legally related to you.

You can set up a CLUT during your lifetime or at death as a form of bequest. Both corporations and individuals may establish lead trusts.

You can set up a CLUT so that you will receive an immediate and sizeable income tax deduction. In the second and following years, you must report the income earned by the trust even though it is actually paid to the charity in the form of an annuity.

What is the advantage of a trust that produces a high deduction in the first year but requires you to report income you don't receive in later years? One advantage is the acceleration of the deduction. For example, suppose you have just won the lottery, closed an incredibly large case, or sold a very highly appreciated asset. Perhaps you reasonably expect that in future years, your income will drop considerably. It's good planning to have a very high deduction in a high bracket year even if you have to report that income in lower bracket years. You are spreading out the income (and the tax) over many years.

Another advantage of the CLUT is that it allows a "discounted" gift to family members. Under present law, the value of a gift is determined at the time the gift is made. The family member remainderman must wait for the charity's term to expire; therefore, the value of that remainderman's interest is discounted for the "time cost" of waiting. In other words, the cost of making a gift is lowered because the value of the gift is decreased by the value of the annuity interest donated to charity.

When the assets in the trust are transferred to the remainderman, any appreciation on the value of the assets is free of either gift or estate taxation in your estate.

Many people of wealth set up CLUTs at death through their wills. The present value of the charity's annuity stream is deductible for estate tax purposes. Since your heirs don't pay estate taxes on the charity's portion, the money that otherwise would have been paid in estate taxes can instead be invested. During the term of that trust, increased investment income can help pay for the fixed annuity promised to the charity - and if there is any "surplus", that extra income can be compounded for your heirs and pass to them - gift tax free - when the trust ends.






Charitable

Naming a Charity as Beneficiary of Group Term Life


This calculation determines the amount of annual income tax savings possible by naming a charity as the revocable beneficiary of group term life insurance in excess of the first (already income tax free) coverage. Usually, the cost of up to $50,000 of group term life insurance coverage is not reportable as income but cost of coverage in excess of $50,000 of coverage is taxable to the employee under so called "Table I" rates.

This technique, specifically sanctioned by Internal Revenue Code Section 79(b)(2)(B) has a number of advantages. First, it is simple. Nothing more is involved than making a revocable assignment of the death benefit to a qualified charity. Second, the tactic "freezes" Table I income tax costs for every year that the charity remains a beneficiary. If, in some later year, a noncharitable beneficiary named for the amount in excess of $50,000, the insured employee will then have to report income but will not have to report any income for the years in which the charity was named the beneficiary.

No income tax deduction is allowed since only a fraction of the insured's interest is given. To qualify for this "income freeze," the charity must be named the sole beneficiary of the excess portion for the entire tax year. Any question about this being a partial interest gift can be avoided by naming the charity the beneficiary of all the entire proceeds rather than merely the excess over $50,000 although this is probably a fractional interest in the group insurance so the partial interest rule should not apply. We suggest being conservative that the charity be named the beneficiary of the entire amount. Insurable interest should not be a problem in most states but should be checked.

As noted above, the cost of group-term life insurance protection in excess of $50,000 is not taxable to an individual who names--even revocably--a qualified charity as the beneficiary of the excess coverage. Although no income tax deduction will be allowed for the gift, no income tax is reportable regardless of how much the employer has paid.






Charitable

Interrelated Estate Tax


Wills (and revocable trusts) are sometimes written so that the federal estate tax (and state death taxes, if any) are paid out of a fund that would otherwise qualify for a charitable deduction. This usually happens because there are gifts to friends and family members that result in federal estate tax, all or part of the residue of the estate is paid to charity, and the residue of the estate must pay the federal estate tax. The charitable deduction is based on what the charity actually receives, after all taxes are paid, so the charitable deduction is reduced by the federal estate tax that is payable on the value of the noncharitable interests in the estate.

The noncharitable interests that generate estate tax might be cash gifts of specific amounts to family members, or they might be a fractional shares of the residue, or they might be annuity or unitrust interests payable from a charitable remainder trust that produces a charitable deduction for only a fraction of the value of the residue passing into the trust.

For example, a person might have made taxable gifts during lifetime that have used up all (or most) of the applicable exclusion amount, and might then die with a will leaving additional gifts of specific amounts (or specific property) to various family members and the rest of the estate in a charitable remainder trust that pays an annuity to the decedent's children for the rest of their lives. Depending on the ages of the children and the amount of the annuity, the charitable deduction might be a relatively small fraction of the value of the residue of the estate. The estate tax will be based on the total value of the estate less the present value of the charitable remainder, and the estate tax will reduce the residue of the estate and the amount passing into the charitable remainder trust.

Because the federal estate tax both reduces the charitable deduction and is itself not deductible, the calculations of the charitable deduction and federal estate tax become “interrelated” or circular. The federal estate tax reduces the charitable deduction, which increases the estate tax payable, which further reduces the charitable deduction, which further increases the federal estate tax, and so forth. Fortunately, the numbers will “converge” on a result that then does not change with repeated calculations.

Once the federal estate tax liability is known, it is relatively easy to prove the correctness of the calculation by using the estate tax liability to calculate the charitable deduction, and then using the charitable deduction to calculate the federal estate tax. If the resulting federal estate tax is the same as the initial federal estate tax, then the results are correct.






Estate Planning Techniques

Estate Tax Advantage of Gift Tax Exclusion


Calculates the estate tax savings possible through the use of the annual gift tax exclusion.

In 2013, donors can donate $14,000 worth of gifts to any number of persons or parties each year, tax free. This allows taxpayers to make many small gifts without recording or reporting them. The maximum amount that may be excluded is calculated by multiplying the number of persons given gifts by the annual exclusion amount. The annual exclusion amount may change each year.

If the donor is married, his spouse may sign the donor's gift tax return as an indication that each spouse donated half the gift, even if the gift was actually donated by one spouse. Therefore, the per-donee exclusion increases to twice the annual exclusion amount, or $28,000 each year.

An annual exclusion is permitted only for "present interest" gifts. A gift is considered present interest when the person receiving the donation has immediate, unfettered, and ascertainable possession, use, or enjoyment of the gift when it is made. A future interest gift is one in which the possession or use or enjoyment of the gift is deferred - even for a moment. Future interests include reversions and remainders.

Single transfers are sometimes two gifts that have to be separated for tax purposes. One gift may be a present interest that qualifies for the annual exclusion, while the other gift may be a future interest that does not qualify for the annual exclusion. For example, a donor puts $14,000 into a trust with a 12% interest rate. His son receives income annually from the trust for 10 years and his daughter is paid the remainder at the end of the 10 years. The son's income payments begin and "vest" (i.e., can't be taken away) immediately; therefore, the gift of the income stream is a present interest gift and qualifies for an annual exclusion. The daughter will not receive the remainder for 10 years; therefore, the gift of the remainder is a future interest and does not qualify for an annual exclusion.

This illustration shows the incredible estate tax saving power of small gifts made to a number of donees over a long period of time in a systematic manner.






Estate Planning Techniques

§6166 Installment Payment of Estate Tax


This calculation determines if an estate meets code §6166 requirements. That Code Section allows a four-year deferral of tax (interest only is payable) and then requires the unpaid tax be paid, together with interest, over an up to 10-year period. It then calculates the limit of the amount that can be deferred and paid in installments and the amount of tax that is due immediately. It computes the "two percent" amount, that is, the amount of tax upon which an extremely favorable 2% rate can be paid and the amount eligible for 45% Underpayment Rate, (any balance of tax) and then the annual payments and the after-tax cost to make those payments.

Code §6166 was created to alleviate an estate's liquidity problems. If the estate qualifies to use §6166, an executor may use installment payments to pay the federal estate tax attributable to the decedent's interest in a closely held business.

Generally, 2% interest is applied to the tax generated by the incremental estate tax on $1,430,000 (adjusted for inflation after 2013) above the unified credit applicable exclusion amount. The "going rate" (a rate of 45% of the interest charged to unpaid income or estate tax) is applied to the balance. Both rates are calculated on a daily compounded basis. To qualify for §6166, the gross estate must include an interest in a closely held business whose value is more than 35% of the decedent's adjusted gross estate. The tax, which may be paid in installments, is the proportion attributable to the value of the closely held business. The balance of the estate tax is paid nine months after the decedent's death.

§6166 is a useful tool when an estate is unable to pay tax without selling assets at a loss. It is also useful when the business or estate is capable of earning a greater after-tax rate of return than it spends in interest for the deferral privilege.

If the estate meets §6166 requirements, the first payment of principal and interest must be paid within five years and nine months from the date of death. Succeeding installments are paid within one year of the previous one. Most planners will recommend that this Code Section be combined with Code §303 in order to use corporate dollars to pay estate taxes and bail those dollars out of the corporation without income tax. Corporate owned life insurance is typically used to finance the corporation's purchase of stock from the estate. That cash is then used year after year to pay for the interest and principal under Code §6166.






Estate Planning Techniques

Business Owner's §2057 Estate Tax Deduction


An executor can elect a special estate tax deduction for qualified "family-owned business interests" if the interests comprise more than 50 percent of a decedent's estate and certain other requirements are met.

In general, this deduction (when used in combination with the unified credit) exempts from federal estate tax the first $1.3 million of value in qualified family-owned business interests in a decedent's taxable estate. The deduction is limited to $675,000, and the total of the deduction and unified credit applicable exclusion amount (which is $625,000 in 1998) cannot exceed $1.3 million. In other words, estates that claim this special deduction will be limited to a unified credit exclusion amount of $625,000, and will not be able to claim the increases in the unified credit for 1999 through 2003.

A "qualified family owned business interest" is any interest in a trade or business (regardless of the form in which it is held) that also meets the following requirements:

1. It has a principal place of business in the US, and

2. At least 50 percent of the trade or business is held by one family, or at least 70 percent by two families, or 90 percent by three families, as long as the decedent's family owns at least 30 percent of the trade or business.


"Members of an individual's family" are defined as:

1. The individual's spouse

2. The individual's ancestors

3. Lineal descendants of the individual, of the individual's spouse, or of the individual's parents, and

4. The spouses of any such lineal descendants


An interest in a trade or business does not qualify if:

1. The business's (or a related entity's) stock or securities were publicly traded at any time within three years of the decedent's death or,

2. More than 35 percent of the businesses' adjusted ordinary gross income for the year of the decedent's death was personal holding company income.


Reduction in value for excess cash, or marketable securities:

The exclusion is reduced to the extent the business holds "excess cash" or marketable securities. Cash or marketable securities in excess of the reasonably expected day-to-day working capital needs reduce the otherwise excludable amount. Cash accumulated for capital acquisitions is not considered "working capital."


Reduction in value for passive assets:

The exclusion must also be reduced by the amount of certain "passive assets." Passive assets include any assets that:

1. Produce dividends, interest, rents, royalties, annuities and certain other types of passive in come

2. Are an interest in a trust or partnership;

3. Produce no income

4. Give rise to income from commodities transactions or foreign currency gains

5. Produce income equivalent to interest.


Other requirements:

In addition to the other requirements stated above, a decedent's estate qualifies for the family business exclusion only if:

1. Decedent was a U.S. citizen or resident at the time of death, and

2. The aggregate value of the decedent's qualified family- owned business interests that are passed to "qualified heirs" is greater than 50 percent of the decedent's adjusted gross estate (the "50-percent liquidity test"). Qualified heirs include not only actual members of the decedent's family but also any individual who has been actively employed by the trade or business for at least 10 years prior to the date of the decedent's death.

3. If a qualified heir is not a U.S. citizen, any qualified family-owned business interest acquired by that heir must be held in a trust which meets requirements similar to those imposed on QDTs (qualified domestic trusts), or must meet other security criterion.


Participation requirements:

To qualify for the beneficial treatment provided, the decedent (or a member of the decedent's family) must have:

1. Owned and materially participated in the trade or business for at least five of the eight years preceding the decedent's date of death,

2. Each qualified heir (or a member of the qualified heir's family) must "materially participate" in the trade or business for at least five years of any eight-year period within 10 years following the decedent's death.






Estate Planning Techniques

Substantially Disproportionate Redemptions


This calculation determines the number of shares that a corporation must redeem (buy back) in order for a redemption from a shareholder to qualify as a "substantially disproportionate" redemption. Substantially disproportionate redemptions are entitled to "sale or exchange" treatment. The calculation performs the "proper number to redeem" calculation by comparing the post-redemption ration with the pre-redemption ratio.

All distributions from a corporation to a shareholder with respect to its stock are considered dividends to the extent of earnings and profits. Dividends are taxed at ordinary income rates. This policy applies even if the recipient shareholder gives up stock in the transaction.

Some distributions, however, are deemed "amounts received in exchange" for the stock, rather than dividends. In this case, the seller pays tax only on the difference between the "amount realized" and the "adjusted basis."

To qualify as an exchange, the transaction must satisfy the requirements of one of several tests. One of these is the "substantially disproportionate" test. Under this test, the transaction is considered an exchange if the distribution from the corporation is substantially disproportionate with respect to the selling shareholder. In short, this means there has been a significant relative change in the shareholder's control, share of profits, and share of assets in case of a sale or liquidation.

A redemption is substantially disproportionate if it meets the following three criteria:

  1. After the redemption, the shareholder owns less than half of the total combined voting power of all classes of outstanding stock entitled to vote.

  2. After the redemption, the shareholder's percentage of total outstanding voting stock is less than 80% of pre-redemption ratio.

  3. The shareholder's post-redemption percentage ownership of outstanding common stock (voting or non-voting) is less than 80% of pre-redemption ownership.


If one of the other stockholders is someone whose stock is attributed to the stockholder (such as a child, wife, etc.) under constructive ownership (attribution) rules, the redemption of the seller's shares will not qualify as substantially disproportionate. The disqualification occurs because the stockholder is deemed to own his own 20 shares, plus the 10 shares attributed to him. His after-redemption percentage would be 30/90 (33.3%), which is more than 80 percent of his pre-redemption percentage (40/100, 40%).






Estate Planning Techniques

§303 Stock Redemptions


This calculation determines if a shareholder such as an estate is entitled to §303 protection. It also calculates the amount of stock that can be redeemed under §303.

IRC §303 allows a corporation to redeem (buy back) a portion of a decedent's stock with a distribution that will not be taxed as a dividend. §303 redemption can provide cash (or other property) from the corporation without income tax at the shareholder level.

§303 is useful when the shareholder's family wants to retain control of a close or family corporation after the shareholder's death. A shareholder's family may find it particularly useful when the corporation's stock is the estate's primary asset, and the family is unable to pay death taxes and other expenses without a forced liquidation of the business.

The following conditions must be met to entitle a shareholder to a §303:

  1. The stock to be redeemed is a part of the decedent's gross estate.

  2. The stock's value is more than 35% of the decedent's gross estate minus deductions allowed for funeral and administrative expenses, debts, taxes, and losses acquired during administration.

  3. The amount redeemed is no more than the total of (a) federal estate, state death, and generation skipping transfer taxes and the interest on those amounts, and (b) funeral and administration expenses (whether or not claimed as a deduction on the federal estate tax return).

  4. Expenses incurred by the decedent's death, administrative expenses, and generation skipping transfer taxes reduce the interest of the shareholder whose stock is being redeemed.


The tax implications of §303 redemption are:

  1. The amount paid to the estate or other seller will be treated as an exchange and not as a dividend. If the stock receives a step up in basis to its value at the shareholder's death, and the corporation pays exactly this price for it, no gain is recognized. If the corporation pays more than the new basis for the stock, the resulting gain is taxed as long-term capital gain with a maximum tax rate of 20%.

  2. Attribution rules do not apply to §303 redemptions.






Estate Planning Techniques

Installment Sale


This calculation evaluates the effect of purchasing a business interest through an installment sale. It calculates the interest and principal payments required in an installment sale. It also provides a schedule of business earnings needed to service a buyout loan, assuming that the interest paid is deductible.

Paying for a deceased co-owner's business interest using the installment method has several drawbacks. These include the following:

  1. The installment method may not produce the amount of cash needed by the client's family to cover expenses, such as federal and state death taxes and other estate settlement costs.

  2. The financial security of the decedent's family remains dependent on the success of the business.

  3. The cost can be very high, even if interest on the unpaid balance is deductible.


Potential buyers must consider the typically high cost involved with a buy-out. For example, assume a buyer plans to purchase a $1,000,000 business interest. He or she will pay ten annual principal payments of $100,000 a year, plus 10% interest on the unpaid balance. If the buyer is in a 35% income tax bracket, the business needs to earn $2,088,460 to service the loan.






Estate Planning Techniques

Group Term Life Cost (Table I)


This calculation determines the amount an employee must include in reportable income to reflect certain life insurance coverage provided by an employer.

Group term life insurance is a taxable economic benefit that must be included in an employee's reportable gross income. Generally, the first $50,000 of coverage is income tax free. Any coverage in excess of $50,000 is taxable. If the employee contributes to the coverage, the amount contributed is deducted from the taxable portion of the coverage.

The taxable portion is calculated using the following steps:

  1. The total amount of group term coverage on a monthly basis over a tax year is calculated.

  2. $50,000 is deducted from each month's coverage.

  3. The appropriate rate from Table I of the government regulations is applied to the coverage.

  4. Employee contributions, if any, are subtracted from the total.


Regardless of the amount, the cost of group term life insurance is tax exempt if any one of the following conditions exists:

  1. The employee has retired on disability.

  2. A charity is the beneficiary of all or part of the proceeds during the tax year.

  3. The employer is the beneficiary.


Retired employees in nondiscriminatory plans also are subject to tax on the cost of insurance in excess of $50,000.






Estate Planning Techniques

Advantage of Income Shifting


In addition to saving federal estate tax (and possibly state death taxes), lifetime gifts within a family can save income taxes for the family as a whole when gifts of income-producing investments are made by a higher-income taxpayer to a lower-income taxpayer, because the investment income is then taxed at lower tax rates.

This model calculates the federal income tax saved from shifting investment income from a parent in a higher income tax bracket to a child (over the age of 18) in a lower tax bracket, showing both the projected savings in the first year and the cumulative savings over time (in 5 year increments).

The model starts with the value of the investment and the yield on the investment, the taxable income of the parent (donor) and child (donee) other than the income from the investment, and the filing status of the parent and child (married filing jointly, married filing separately, unmarried, and head of household), and calculates the tax on the investment income in the hands of the parent versus the tax on the same investment in the hands of the child, the top marginal tax for the parent and the child, and the average rate of tax on the investment income for each of them.

The top marginal tax rate is the federal tax rate that applies to the last dollar of income when the investment income is added to the parent's or child's other taxable income.

The average tax rate is the average of the different tax rates that can apply to the investment income when that investment income is added to the parent's or child's other income. So, for example, if an investment produces an income of $10,000 per year and, in the hands of the child, $3,000 of that income would be taxed at 15%, because the child's other income has already “used up” all of the 10% bracket and the rest of the 15% bracket, then the remainder ($7,000) would be taxed at 25%. The average rate of tax on the investment income would then be 22%, because 15% of $3,000 is $450 and 25% of $7,000 is $1,750, for a total tax of $2,200 on $10,000 of income.

The model also assumes that the income produced by the investment are re-invested at the same rate as the original investment.

Note: This calculation does not include future inflation adjustments, possible reductions in personal exemptions or itemized deductions due to increases in income, the Sec. 1411 tax on net investment income, or other non-rate consequences.







Taxes

Gift and Estate Tax Computation


This calculation computes the gross gift or estate tax, applies the proper unified credit, and determines the net tax payable. It also calculates the remaining net estate and the effective tax rate as a percentage of the net amount passing to the beneficiaries or donees after taxes.

The effective gift tax rate is less than the effective estate tax rate even though the taxes are calculated using the same unified table. The effective gift tax rate is lower because the gift tax is based on the amount received by the donees after taxes, while the estate tax is calculated on the value of the estate before taxes. In other words, the donor of a gift is not required to pay any gift tax on the money paid in gift tax.

The estate and gift taxes are based on a series of graduated rates that start at 18%. However, each person is allowed a unified credit that eliminates the tax in the lower estate and gift tax brackets.

The program can also calculate the state death taxes (if any) imposed by any of the 50 states or the District of Columbia. For years after 2004, the state death tax is deducted from the taxable estate in calculating the federal estate tax.






Taxes

Prior Gifts


This utility calculates the unified credit allowed by prior gifts, as required by IRC section 2505(a)(2), and the gift tax payable on adjusted taxable gifts that are included in the tentative tax base for federal estate tax purposes, as required by IRC section 2001(b)(2) and (g). As will be explained below, these results are needed for federal estate and gift tax calculations when more than $500,000 of taxable gifts were made before 2010 because taxpayers can no longer rely on the amounts reported on the gift tax returns that were filed for those prior gifts.

Under the unified (and progressive) gift and estate tax system created by the Tax Reform Act of 1976, gift tax calculations are cumulative, so that each taxable gift during the taxpayer's lifetime pushes the taxpayer into higher gift tax rates. Similarly, gifts made during lifetime are added to the taxable estate in calculating the estate tax due at death, and so lifetime gifts pushes the taxpayer's estate into higher estate tax brackets.

A “unified credit” against the gift tax and estate tax provides an exclusion for gifts up to a certain total amount during lifetime, or an exclusion for a taxable estate of up to a certain amount.

Under this system, certain problems can arise when a taxable gift is reported during lifetime at one tax rate, and tax is paid (or unified credit is used) at that tax rate, but the tax rate is later changed. IRC section 2001(b)(2) has always addressed part of the problem by providing that the gift tax that is considered to have been payable on the taxable gifts that are included in the estate tax calculation must be redetermined using the tax rates in effect at the decedent's death, and not the tax rates in effect at the time the gifts were made. So, for example, if a decedent had made a taxable gift and paid a tax of 45%, but the tax rate were only 35% at the decedent's death, the inclusion of the gift in the estate tax calculation would add 35% to the tentative tax and section 2001(b)(2) would subtract that same 35% from the tentative tax. In that way, the inclusion of the gift in the estate tax calculation neither increases nor decreases the estate tax payable, but simply insures that the taxable estate is taxed at the intended rate.

A new problem arose in 2010, when the reduction in the top gift tax rate from 45% to 35% actually changed the amount of the credit allowed. When the top gift tax rate was 45%, the credit was $345,800, which is what the tax would be on $1,000,000. When the top gift tax rate became 35%, the tax on $1,000,000 became $330,800, which became the credit amount in 2010. If a taxpayer had made gifts of $900,000 in 2009, when the top tax rate was 45%, and then made a gift of $100,000 in 2010, intending to use up the rest of the $1,000,000 exclusion, there might be a tax of $11,000, because the 2009 gift would have used up $306,800 of credit, leaving only $24,000 of credit in 2010, while the $100,000 gift would result in a tax of $35,000.

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 therefore made the following changes:

1. IRC section 2001(b)(2) has been amended, and a new subsection 2001(g) has been added, to require that, in calculating the gift tax payable on the adjusted taxable gifts that are included in the estate tax calculation, the tax rates that are in effect at the decedent's death must be applied both in calculating the tentative tax on the gifts and in calculating the credit allowed and the tax payable on those gifts.

2. IRC section 2505(a)(2) has been amended to require that the "credit allowed" for gifts in previous years must be redetermined using the rates in effect for the current year and not the rates in effect in the year in which the gifts were made.


The program makes these calculations by allowing the user to enter the amounts of the taxable gifts made each year, and then recalculating both the unified credit allowed for those gifts and the gift tax payable on those gifts by applying the tax rates in effect at the time of the decedent's death or, for a gift tax calculation, the rates in effect in the year the gift is made. The results can then be applied in calculating the gift tax or estate tax currently payable.






Taxes

Projection of Estate Tax


This illustration estimates the burden of federal and state death taxes at the death of the second to die of a couple. It is an important calculation for planning an estate and providing sufficient cash to meet tax and other needs.

The unlimited marital deduction, for those who qualify, postpones federal estate taxes (and in some cases indirectly postpones state death taxes) until the death of the survivor of a married couple.

Unfortunately, although there may be more flexibility while the surviving spouse lives, at his or her death, the "2nd Death Wallop" occurs. At this point, the federal and state death taxes are imposed on what often is a much larger estate than anticipated. Many executors (and especially those where the family business or some other relatively non-liquid asset comprised the bulk of the wealth) are shocked and dismayed at the large amount of cash that must be raised to pay federal and state taxes as well as administrative costs.

There are numerous solutions to a "liquidity need" (cash must be raised to pay federal and state death taxes as well as legal and accounting fees and probate costs within nine months of death) problem.

Most estate planners utilize life insurance in one form or another to create the cash to satisfy that need. Survivorship ("2nd to Die") coverage is one approach. Here two lives are insured but payment is made only when the second death occurs. In some cases, the premiums are lower then if two individual policies are used. Medical underwriting standards may be eased somewhat for survivorship coverage due to the fact that the insurer will not have to pay until the second death occurs. Some authorities also claim that if a split dollar plan is used, the "P.S. 58 cost" will be significantly lower than if individual policies are used. Insuring the younger healthier spouse or both spouses is an alternative.

Regardless of which policy arrangement is selected, the concept of creating cash at the second death of two individuals is a sound estate planning technique. It should not ignore the importance of adequate planning for the inevitable (and sometimes surprisingly high) costs at the death of the first spouse to die.






Taxes

Marital Deduction Optimization


This calculation computes the marital deduction that is the smallest deduction allowable without federal estate tax (or, if federal estate tax is unavoidable, the largest deduction allowable).

There is an estate tax deduction for property passing to a surviving husband or wife, and so there is no federal estate tax if the entire estate is left to the surviving spouse. However, there is also a unified credit for each decedent which provides an exclusion from tax. An effective (and common) effective estate planning technique to use both unified credits is to change the wills or revocable trusts of the married couple so that, on the first death, the unified credit exclusion amount does not pass to the surviving spouse but is held in a trust for the benefit of the surviving spouse. In this way, the surviving spouse can get the income and benefit of the property held in the trust without the property being part of the survivor's estate. Upon the death of the surviving spouse, the property in the trust passes to (or in further trust for) the children or other intended beneficiaries free of tax. (See the Bypass Trust Computations to calculate the benefit from this trust arrangement.)

A separate (but related) problem is the federal estate tax that can result when there are gifts at death that do not qualify for the federal estate tax marital deduction and the non-deductible gifts exceed the unified credit applicable exclusion amount. Because the federal estate tax that is paid out of the estate does not qualify for any deduction and reduces the amount available for the marital deduction, there is a resulting "tax on tax" because the tax that is paid increases the tax that must be paid. The program can solve this kind of recursive (or circular) calculation.






Taxes

Table 2001 (P.S. 58) Cost


The cost of life insurance protection provided under a split dollar plan or under a qualified pension, annuity, or profit-sharing plan is treated as a current economic benefit (the equivalent of cash) made available to the employee by the employer or as a distribution by the pension or profit-sharing trust.

The value of this currently reportable benefit must be included in the employee's gross income for the year in which the premium is paid. This rule is applicable even if the policy is on the life of a third party. For example, a shareholder might enter into a split dollar agreement under which he insures the life of a co-shareholder to fund a buy-sell agreement.

The employee is taxed currently only on the "net amount at risk," i.e., on the cost of the life insurance protection actually provided on behalf of the employee. This cost is found by multiplying the one year term premium rate at the insured's attained age (age on birthday nearest the beginning of the policy year) in the government's table (2001) by the difference between (a) the face amount of insurance and (b) the cash surrender value at the end of the policy year.

As noted above, if the insurer's rates for individual one year term policies available to all standard risks (initial issue insurance) are lower than the table rates, the lower rates may be used. But, so-called "fifth dividend option" rates may not be used. No extra charge is imposed on substandard insureds; the same table rates that apply to standard risks are used for employees who are insurable only at substandard ratings.

If an employee under a split-dollar plan receives dividends, they may constitute additional compensation. The general rules are:

1. Dividends received in cash are taxable.

2. Dividends used to purchase one-year term insurance under the fifth dividend option are taxable.

3. Dividends applied to purchase paid up life insurance are taxable if the employee has a non-forfeitable interest.

4. Table 2001 (P.S. 58) cost, or yearly renewable term cost if lower, is reportable if dividends are used to purchase paid up additions and the employer is entitled to the cash surrender value and the employee's beneficiary receives the balance of any death benefit.

5. If dividends are left on deposit and the employee is given a non-forfeitable right to those amounts, the dividend must be included in the employee's income.

6. If dividends are used to reduce the premium, they are not included in the employee's income.

The value of all economic benefits received by the employee in the tax year (Table 2001 value for the life insurance protection plus the dollar value of dividends received by or paid for the benefit of the employee) are aggregated. Then the payment made by the employee (or other policy owner) is subtracted from the total value of the economic benefits provided. The balance, if any, is the amount the employee must report as income.

If the employee's portion of the premium for a given year is greater than the value of the benefits he receives in that year, the excess can never be carried over. It is lost.






Taxes

Tax on a Net Gift


This calculation determines the tax on a net gift as well as the tax reduction that results from the net gift (because the donor has made a smaller gift).

A net gift results when the donee agrees to pay the gift taxes on the transfer because the amount of the gift is reduced ("netted") by the gift tax to be paid by the donee. Net gifts are good ways of transferring property when:

  1. The donor does not have sufficient liquid assets to pay gift taxes and does not want to sell other property to raise cash.

  2. The donor wants to limit the gift to its net value.


Those considering net gifts must consider both gift tax and income tax implications.

The gross amount of the gift is reduced by the amount of the gift tax paid by the donee.

The gift tax is then computed on the remaining or net amount of the gift.

For income tax purposes, a net gift is considered partially a sale and partially a gift. A taxable gain results when the gift tax paid by the donee exceeds the donor's basis in the property.






Taxes

Individual Income Tax


This calculation is a simplified estimation of the income tax payable in any year (1991 to current year), or estimates the tax payable in future years) for taxpayers filing joint, single, separate, and head of household tax returns.

Additionally, the calculation determines your effective total tax rate and effective marginal tax rate.






Taxes

Corporate Income Tax


This calculation determines the tax payable for the years 1987 to 2013 by C corporations, personal service corporations, and trusts and estates. The taxpayer's net income after payment of the tax, the top marginal bracket, and the percentage of total income lost to federal income tax are also computed.

This calculation determines the corporation's federal tax payable and the net income after payment of the tax. Also calculated are the top marginal bracket and the percentage of total income lost to the federal income tax. These calculations are also performed for service corporations and trusts/estates.






Retirement

Lump Sum Distributions


This calculation determines the tax due, the amount remaining, and the effective tax rate on a lump sum distribution from a qualified pension or profit sharing plan if the lump sum qualifies for ten year averaging at the 1986 rate, five year averaging at the last year's rate, and five year averaging at the current year's rate.

Lump sum distributions from a qualified pension of profit sharing plan must be included in reportable gross income and taxed at ordinary rates. In certain cases, special five-year income averaging is still available which may result in considerable tax savings.

A lump sum qualifies for this one-time five-year income averaging election only if all of the following requirements are met:

  1. The sum is received after the recipient turned 59½ years of age.

  2. The sum is paid within one tax year.

  3. The sum is the entire distribution of the employee's benefit in the plan. (All pension plans maintained by an employee are considered a single plan. This also applies for profit sharing and stock bonus plans.)

  4. The sum is payable for one of the following reasons:

1. The participant has died

2. The participant has attained age 59½

3. The employment of a non-self employed individual has been terminated

4. A self-employed individual has become disabled.

  1. The sum is distributed from a qualified plan (not an IRA or 403(b) tax-deferred annuity).

  2. The employee participated in the plan for at least five years prior to the distribution (this requirement does not apply to a death benefit).


If the lump sum distribution meets all of the above qualifications, it is eligible for five-year averaging.

In some cases, certain tax benefits available before 1987 for lump sum distributions have been grandfathered for existing participants.

Such participants may choose to treat the amount accumulated prior to 1974 as a long-term capital gain. If the participant was in the plan prior to 1974, the distribution is divided into two amounts, a pre-1974 amount and a post-1975 amount. The pre-1974 amount is taxed at a 20% rate (the capital gain maximum). This capital gain treatment is phased out in the following manner: only 95% of the pre-1974 amount is eligible in 1988, 75% is eligible in 1989, 50% in 1990, and 25% in 1991.

This capital gain treatment is not required. The entire distribution can be treated under current five-year averaging if the participant so chooses. Any part of the distribution that does not qualify for capital gains treatment can (if it does) qualify for five year averaging.

From 1974 through 1986, ten-year averaging was applied to lump sum distributions. This practice is still available for individuals who attained age 50 before January 1, 1986. Such individuals who receive a distribution after 1986 may use ten-year averaging with the 1986 tax rates instead of five-year averaging with current rates. This practice is recommended if it results in lower taxes.






Retirement

Retirement Plan Taxation


This calculation determines the potential impact of three federal taxes (and in some cases state death tax) on a distribution from a retirement plan to a grandchild. It shows how little remains after:

  1. federal estate and state death tax,

  2. The generation skipping transfer tax, and

  3. The lump sum income tax on retirement distributions after a participant's death.


Before a grandchild receives a retirement distribution at the participant's death, the sum is subject to the federal estate tax, the generation skipping transfer tax, and the lump sum income tax. These taxes have a significant impact on the distribution amount actually received by the grandchild.

A description of each tax follows:


  1. The first set of taxes is death taxes, the federal estate tax and state death tax. The death taxes attributable to the plan are calculated to be the increase in taxes caused by the plan.

  2. The second tax is the generation-skipping transfer tax (GSTT). When the distribution is to a grandchild or another beneficiary who is two or more generations younger than the transferor is, the distribution may be subject to the GSTT tax. This GSTT tax is applied at a rate equal to the highest federal estate tax rate on every taxable dollar. A GST exemption will shelter the smaller estates, and if used to buy life insurance owned by a third party, can be leveraged to provide protection from this high tax.

  3. The third tax is the federal income tax. The federal estate tax and the generation-skipping tax may be deducted before the income tax liability is imposed. The program performs a precise calculation of the §691(c) deduction for the increase in the net federal estate tax caused by the plan.






Retirement

Pre-59½ Distributions


This calculation determines the amount of money that can be taken out of a qualified pension plan or IRA before age 59½ without incurring the 10% penalty on those distributions.

The 10% "distribution" penalty applies to lump sum distributions, deemed distributions, and both voluntary and involuntary cashouts (unless the amount of the cashout is rolled over to another qualified plan or IRA).

The IRS states that the money must be taken out in "substantially equal periodic payments." These payments are made not less than annually for the life or life expectancy of the employee or the joint lives or life expectancies of the employee and beneficiary.

The penalty does not apply to the following distributions:

  1. Distributions made after age 59½

  2. Distributions made to the beneficiary of the plan or their estate on or after the participant's death

  3. Distributions made because of the permanent disability of the participant

  4. Distributions made after separation from service after age 55 (this does not apply to IRAs)

  5. Distributions made to a former spouse, child, or other dependent of the participant if made under a QDRO-Qualified Domestic Relations Order - (does not apply to IRAs)

  6. Distributions made to the extent of medical expenses whether or not they were actually deducted (does not apply to IRAs)


There are three methods by which to calculate these distributions: Minimum Distributions, Amortization, and Annuity Factor. This program computes the two latter methods.

The Amortization Method allows the amount that is distributed annually to be calculated by amortizing the employee's account balance over a number of years equal to the life expectancy of the account owner or the joint life expectancies of the account owner and beneficiary. Life expectancies are to be determined in accordance with IRS regulations with an interest rate beginning on the date the payments commence that does not exceed a reasonable interest rate.

The Annuity Factor method determines the amount that is distributed annually by dividing the pension owner's account balance by an annuity factor which is derived by using an appropriate mortality table and a reasonable interest rate.






Retirement

Determination of Cash Requirements


This calculation shows the amount of cash an estate's executor must be able to raise within nine months of the death of an estate owner. These include debts, funeral expenses, administration costs (including legal, accounting, and valuation fees), state and federal death taxes. These numbers do not, of course, include the cost of food, clothing, shelter, or college education expenses for family members.

You should compare the estate's assumed liquidity (cash to pay taxes) with the estate's cash needs. A shortfall indicates the need to purchase life insurance, arrange for the estate to borrow sufficient funds under reasonable terms to meet the cash needs, or attempt to reduce cash needs by repositioning assets and using one or more appropriate estate planning tools or techniques. Typically, a combination of these will be required.






Present-Future Value

Present Value of an Annuity


An annuity is a systematic liquidation of principal and interest. The present value of an annuity is the sum of money in current dollars that equals future payments of principal and interest received each year for a specified period at a specified rate of interest.

This calculation is useful for individuals who want to receive $X every year for Y number of years. For example, assume a person wants to receive $10,000 each year for 20 years following his retirement. If 10% could be earned on the invested funds, the investor's initial investment must be a lump sum of $85,136. $10,000 annually for twenty years could be paid to the investor - assuming the 10% rate of return was actually realized. At the end of the twenty years, the fund will be exhausted.

This calculation is also used to determine the current value of any asset that will produce a series of payments in the future on a steady basis at a given interest (discount) rate. An example of such an asset is a lease that will earn a specified amount each year for a specified number of years.






Present-Future Value

Present Value of a Lump Sum


Many individuals want to meet specific monetary goals at particular points in time. For example, you may want to save $100,000 in 10 years to send your two children to school. You want to know how much you have to set aside today.

Likewise, the present value of a future lump sum is a way to decide how much should (or would) be paid today for an asset that will be received in the future. For instance, a person may estimate that he or she will receive a $200,000 lump-sum distribution from a retirement plan in 20 years. While this may sound like a lot of money, the fact that it will not be received for another twenty years makes it worth much less today.

How much less is it worth today? That depends a lot on the "discount rate," the interest rate assumed throughout the twenty-year period.

The higher the discount rate, the lower the present value of a given future amount. Put another way, you would have to invest less today to reach a specific future objective if interest rates were high rather than low throughout the period of time.






Present-Future Value

Deferred Compensation


The use of nonqualified deferred compensation arrangements has grown substantially in recent years. This growth is attributable to many factors including restrictive limits on contributions or accruals for the benefit of the highly compensated under qualified retirement plans, the increasingly burdensome compliance requirements of qualified plans, and the need for more flexible, selective, and cost-effective mechanisms for compensating key employees.

There are many different types of deferred compensation plans, but they all generally have several features in common:

  1. First, they are not subject to the nondiscrimination rules of qualified plans; therefore they may be used to reward only a select group of employees. An employer is free to pick and chose who will be covered and what levels of benefits and terms each will receive.

  2. Second, the deferred compensation is generally credited with interest to compensate the employees for the time-value of money while the compensation is deferred.

  3. Third, if properly arranged, the deferred compensation will not be taxable to the employees until they actually receive it.


Although tax deferral is generally beneficial, it can be counterproductive if an employee's tax rate increases by the time the compensation is actually received. In the current environment of constantly changing tax policy, growing federal and state deficits, and economic uncertainty, predicting future tax rates can be difficult if not impossible.

Therefore, the critical issue for many employees and employers who are contemplating the use of nonqualified deferred compensation arrangements is whether deferral is a sound financial tactic. That is, will employees be better off with the deferred compensation arrangement than they would be without it?

Clearly, if tax rates do not rise, a highly compensated employee will almost always be better off deferring some of his or her compensation until a later date. However, if tax rates do rise, an employee will be better off deferring the compensation to a later date only if the compensation is deferred for a sufficient period to time--the break-even period.

Specifically, if compensation is deferred, the employee will be taxed in a future tax year at a higher future tax rate on the entire amount including the interest credited on the account. If compensation is not deferred, he or she will pay tax at the current lower tax rate immediately and therefore have less available for investment.

The tradeoff is between the current lower tax rate, which must be paid immediately and which reduces the amount available for investment, and the higher future tax rate, which must be paid later and which allows the entire before-tax amount to earn interest.

If the period of time is sufficiently long, the benefit of earning interest on the before-tax amount of deferred compensation will exceed the cost of the higher tax rate that is applied to whole amount when it is ultimately received.

Nonqualified deferred compensation is not deductible by the employer until the compensation is paid to the employee, which means that the employer loses the benefit of an immediate income tax deduction if the compensation is deferred. The program looks solely to the possible benefits to the employee and does not calculate the possible cost of deferral to the employer.






Present-Future Value

Future Value of an Annuity


The future value of an annuity is another way of asking, "How much money would I have after a given number of years if I invest a certain amount regularly?"

For instance, if you save $X a year and earn Y% for Z years, how much would you have? If the value of this regular savings program is less than your monetary goal, the shortfall can be computed and the "future" program can be used to find out how much extra must be invested each year.

Most calculations to figure the "future value of $1.00 per period" are based on the deposit being made at the end of each period. This is referred to as an ordinary annuity, or "annuity in arrears."

If an investment program is started in a given year, the first dollars are not actually invested until the end of that first period. For instance, if investments are made monthly and the starting date is January, the first actual deposit is made at the end of that month.

If payments are made at the beginning of the period (this is called an "annuity due") there will be a larger amount at the end of the period.






Present-Future Value

Future Value of a Lump Sum


This calculation determines the value a lump sum will grow to if compounded at a specified interest rate for a specified time-period.

The future value of a lump sum is what each dollar invested today in a hypothetical bank account, mutual fund, or some other type of investment will be worth at the end of a specified period.

The date that the investment is made designates the start of the investment period. The calculation assumes that no additional funds will be invested or withdrawn during the investment term, and the rate of return will not change.

The Future Value of a Lump Sum calculation is used to determine how much a sum invested today will be worth when that sum is needed, such as upon retirement or when children are ready for college.

The interest rate and investment term has a great effect on the future value of the invested dollars. Higher rates or longer terms result in a greater future value. For example, if $10,000 is invested at 12% interest for five years, the resulting sum is $17,623. If the same amount is invested at 13%, or if the term is increased to 6 years, the resulting sum is significantly higher.






Present-Future Value

Deposit Growth


This calculation shows the effect of compound interest on a hypothetical investment by showing how money grows at various interest rates. It calculates the future value of money at three different interest rates for compounding periods of up to 50 years.

This calculation demonstrates the significant effect that compounds interest has on money. It does this by compounding three lump sums at three different interest rates.

The calculation also illustrates the importance of shopping around for a higher interest rate. Even a slightly higher rate results in a significantly greater future value.

For example, a lump sum of $10,000 at 10% interest for five years would result in a sum of $16,105. The same lump sum for five years at 12% interest results in $17,623, a difference of $1,518 over only a short period of time.






Present-Future Value

Life Expectancy


In many cases, a planner could design nearly perfect financial and estate plans for you --if he or she knew exactly when you would die. But since no one has that knowledge, estate and financial planners typically make plans based on expectations of probabilities, i.e., what is likely to happen in the "average case."

Mortality statistics based on the longevity of large numbers of people can provide strikingly accurate guidance as to what is the average remaining life expectancy for an average person at a given age. Of course, no real person is "average" and factors such as one's family history of longevity, current and past health problems, occupation, avocation, and lifestyle should all be factored into any plans that are dependant on how long one lives. The use of life expectancies - that is the use of mathematical probabilities provides a starting place, a frame of reference for making important decisions - and once found, reasonable adjustments can be made to suit the calculations to a specific person.

Since much of financial and estate planning is conducted for married couples, both single life and joint life expectancy statistics and various relevant joint life probability statistics are illustrated.

A word about the mortality tables upon which our actuarial longevity probabilities are based: One of four mortality tables were used for computing the life expectancy and probability statistics: (1) the 2000CM table (2) the Sec. 1.401 (a) (9) table (3) the 90CM table (4) the 80CNSMT table, and (5) the Sec. 1.72 table.

The Sec. 1.401(a)(9) table and Sec. 1.72 table can be found in those sections of the tax regulations, and both are derived from the experience of companies that sell annuity contracts. People who choose to invest in annuities are usually healthier than the population as a whole, and so tend to live longer than people of the same age in the population as a whole. As a result, these mortality tables tend to show longer life expectancies than the tables based on census results (which are based on the population as a whole). The Section 72 table is the IRS table for determining the expected return for annuity contracts and the exclusion ratio for the recovery of cost basis in an annuity contract. The Section 401(a)(9) table is newer and is used for the purpose of determining the minimum required distributions from IRAs and qualified retirement plans, as well as early retirement distributions under section 72(t). Both tables are useful when you need life expectancy statistics for people who are healthier than average for their age and who are considering the use of annuity type products to meet their financial goals.

Table 80CNSMT, Table 90CM and Table 2000CM are IRS mortality tables used for determining the gift and estate tax values of various component interests in property. Table 80CNSMT is used for dates prior to May 1, 1999. Table 90CM is used for dates prior to May 1, 2009 and later than April 30,1999. Table 2000CM is used for dates after April 30, 2009. For dates May 1, 1999 through June 30, 1999, Table 80CNSMT or Table 90CM may be used. Since the tables are used to value both life interests and remainder interests, they must be basically neutral, neither favoring nor discriminating against one component interest (e.g., a life interest) over another (e.g. a remainder interest). Consequently, life expectancy and probability statistics based on the tables are more representative of the population as a whole than those based on the Section 72 table. The tables are most useful when you want life expectancy statistics for the "average" case; that is, for a person who theoretically has been pulled at random from the population as a whole with no self selection bias for either longer than average or shorter than average longevity.

All the mortality tables discussed above are "unisex tables." That is, for policy reasons, the mortality statistics were designed to reflect the experience of both males and females. Although differences in male and female mortality have diminished in recent years, they have not been entirely eliminated and therefore to some extent adjustments may be made to increase "accuracy."

If you wish to generate life expectancy and probability statistics that more accurately reflect sex-based mortality factors, you can adjust the ages in the following manner:

1. Increase the age of a male by 2 years and

2. Decrease the age of a female by 4 years. Although these adjustments will not exactly correct for the actual sex-based factors, for most ages (less than age 95) the life expectancy statistics generated by this program will differ from actual sex-based life expectancy statistics by less than one-tenth of a year.






Present-Future Value

Chance of Survival


Although it is impossible to know the life expectancy of any one person, it is possible to estimate life expectancy or chances of survival to a given age based on a large number of individuals through actuarial tables.

Table 2000CM, the mortality table used by this calculation, is the table based on the 2000 census. The IRS uses this table to calculate life expectancy and the probability of survival at given ages. This table is the basis for the actuarial assumptions and tables released under Code Section 7520 in Notice 89-60.

Note that the expectancies in this table will usually not match those of annuity tables since those tables presume a more select (healthy and long-lived) group. For example, under Section 72 tables, a 65-year-old has a 20-year life expectancy while under the 1980 table life expectancy would only be about 16 years.

If the 1980 CSO Gender Adjustment is selected, then the probabilities are calculated by adding 2 years to the ages of males and subtracting 4 years from the ages of females. So, for example, if age 57 is entered for both a man and a woman, the probability of the man dying would be based on age 59 and the probability of the female dying would be based on age 53.






Investment

Common Stock Calculator



Common stock represents an ownership (equity) interest in a corporation. Each common stock shareholder is entitled to a proportionate share of the control, profits, and assets of the corporation. Stockholders exercise control through voting rights and receive a share of corporate profits through dividends. In the event the corporation is sold or liquidated, owners of common stock share the net proceeds.

Common stocks have enjoyed a long-run average annual rate of return almost twice that of fixed-income investments. Returns on stocks have averaged nine to ten percent over the last fifty years while fixed-income securities such as corporate bonds and government securities have averaged only four percent.

Gain or loss on common stock is defined as the difference between the amount received on the sale of the stock and the investor’s basis, that is, the total cost including commissions paid in buying and selling the shares.

Dividends represent the common stockholders’ share in the earnings and profits of the corporation. Cash dividends are generally paid by most corporations on a quarterly basis. "Dividend yield" is calculated by dividing the annual dividend rate by the market price of the stock.

The price-earnings (P/E) ratio is the stock’s current market price divided by the company’s most recent twelve-months’ earnings.

Uses include:






Investment

Comprehensive Bond Calculator


A bond is the legal evidence of a long-term loan made by the bondholder to the corporation that issued the bond. Typically, the loan must be repaid as of a specified date, the maturity date. Until the bonds are redeemed (paid off by the corporation), interest is paid semi-annually by the corporation to the bondholder at a specified rate. The interest rate payable by the corporation is generally fixed when the bonds are issued and does not change during the life of the bond. The interest rate to be paid can be found on the face of the bond itself, or is shown in newspaper listings such as the Wall Street Journal under bond trading activity.

Bonds are commonly evaluated on the basis of current yield and yield to maturity. Current yield is the return based on the current market price of the bond and is calculated by dividing the annual interest amount by the current market price of the bond. Yield to maturity is the rate of return on a bond held to its maturity date and redeemed by the issuer at its par value. Yield to maturity includes any gain (or loss) if the bond was purchased below (or above) its par value.






Investment

Annual Rate of Return


One of the most important factors in evaluating any investment is the rate of return expected. Once this is known (or estimated), a potential investment can be compared with other alternatives. For example, a purchase of common stock might be compared with a real estate investment.

Of the three factors involved in the calculation, only the present value or cost is generally known with certainty, though it may be subject to negotiation. The investment's future value and how long the investment will be held can only be estimated. This lack of knowledge can lead to wide variations in the estimated rate of return from the investment. For example, an investment that doubles in value in five years will yield a 15% (approximately) return while one that takes eight years to double will provide only a 9% (approximately) return.

Risk is another factor that must be taken into account in any investment situation. Investments that involve greater risk should provide higher rates of return to compensate the investor for the increased risk. An investor would be foolish to accept a 7% return from a speculative, high-risk investment when approximately the same return is available from relatively secure certificates of deposit and money market funds
.






Investment

Investment and Cash Flow Analyzer


The outcome of any investment program reflects the combined impact of several variables. Some of these are under the control of the investor and others are not. The investor can usually manage the amount of the beginning investment or can begin an investment program without any beginning balance. Additional contributions to the fund also are generally under the individual's control.

Withdrawals may be at the discretion of the investor, but are usually influenced by outside factors as well. For example, a fund may be created to pay for a child's college education. The amount of each withdrawal will depend on tuition charges and other fees that are outside the investor's control. Also, other funds may become available to pay the education costs, and the fund may remain intact.

Another very important factor affecting the value of the fund over time is the rate of return earned on the investment. A high rate of return may allow smaller contributions to be made in order to reach a particular goal. Alternately, a high return may permit larger withdrawals than would otherwise have been expected. A low rate of return may force larger contributions or result in smaller withdrawals.

The time horizon of the investment will also affect the value of the fund. Compound interest is a powerful force, but it normally has its strongest impact of relatively long time periods. The bulk of earnings from interest will come during the last years of an investment period.

The value of this calculation is its ability to show the combined effect of all of these factors, and to allow the user to make changes and determine the impact of those changes on the investment outcome
.






Investment

Holding Period Return Calculator


Holding Period Return (HPR) is the total return earned from holding an investment from a specified period of time. It represents the sum of current income as well as any gains or losses during the holding period divided by the beginning investment value.

The formula for determining holding period return is:

HPR = [current income gain (or loss)] / beginning investment value

This equation assumes that gain or loss is equal to the ending investment value less the beginning investment value.

HPR provides a quick and simple method for measuring the total return realized on or projected from an investment. The major flaw associated with the use of the HPR method is its failure to consider the time value of money. For instance, assume two investments, each requiring a $10,000 outlay, each projected to return $1,000 over a one-year holding period, and each expected to retain its original value. If one of the two returns $1,000 at the end of six months while the other pays $1,000 at the end of the year, obviously, the first investment is preferable (assuming equal safety of principal).

Since it is generally best to receive a given return sooner than later, time is a critical factor in the process of evaluation and selection of investments
.






Investment

Present Value of Investment


Present value computations provide quantitative techniques for determining the impact of time on financial decision making. The present value concept is essential in understanding the effect of time on the profitability of an investment, how the projected value of an investment's future economic returns affects the price that should be paid for it now, and how to compute the value of an investment's future economic return.

Investment, by definition, implies a delay in consumption or enjoyment. There must be some compensating reward for an individual to forego current consumption or enjoyment in favor of future consumption. That "profit" must be large enough to justify (at least in the mind of the investor) the expected delay. The measure of the profit is typically called the "rate of return" or the "rate of interest."






Investment

Internal Rate of Return


The IRR of an investment is the "discount rate" that causes the present value of future cash flows from the investment to be equal to its current cost. The investment's IRR is used to calculate the percentage rate of return that will be produced by a series of cash outflows and inflows.

IRR computations are used to compare investments or to determine if an investment will be profitable. For example, assume an individual wants to purchase an office building as an investment. Before making the purchase, he should consider the following: (a) the time value of money, (b) the total income that will be received, and (c) funding that will be needed to continue the rent flow (such as repair and renovation costs). He pays $50,000 in initial outlay, estimates net income of $10,000 a year, and plans to keep the building for 10 years.

Given these facts, the calculation determines the IRR to be 20.2%. The individual then compares this discount rate to the cost of borrowing money. If $50,000 can be borrowed for less than 20.2% (and other factors are positive), the investment would be appealing. If the cost of borrowing money were more than 20.2%, the investment would not be profitable.

  1. The IRR approach assumes that future cash inflows can be invested at the same rate as the IRR. This rate, in fact, may not be available.

  2. Cash flows are discounted at the same IRR rate. Occasionally, however, an investor will receive no cash inflow to correspond to a cash outflow. An example of this is leveraged real estate investments. Cash needs must therefore be satisfied with available or borrowed funds. The IRR approach, however, does not recognize the earning rate that money on hand could yield, or the expense incurred by borrowing.

  3. At times, an investment will produce both positive and negative cash flow, which may cause multiple internal rates of return.






Inflation

Erosion of Purchasing Power


Inflation is defined as a period of rising prices. This has the effect of making the same amount of goods or services more expensive year after year. This translates into an erosion in the purchasing power of each dollar owned or earned by an investor.

The inflation rate, which is an indication of the rate of change in prices, is commonly measured by the Consumer Price Index (CPI) which is published monthly by the U.S. Department of Labor Statistics. The current index is calculated relative to prices in 1982-84, the base year. The index for 1982-84 was set at a figure of 100, meaning that $100 would purchase a standard "market basket" of goods and services. That same basket of goods and services would have cost the consumer $152 at the end of May 1990.

While planning for retirement, college funding, or any other long-term goals, it is essential to consider that costs will be higher in the future and that the dollars in a given fund will buy less because of inflation.






Inflation

Fundlife Calculator


It is essential that the adequacy of a retirement fund or other special fund be tested. Adequacy implies that if money is withdrawn from the fund at a stated rate over a given period of time, that it will satisfy the purpose for which it was intended.

If the analysis shows that a particular rate of withdrawal is too great or the expected rate of return that replenishes the fund is too low, withdrawals may have to be reduced, or a more aggressive investment policy may have to be pursued. This calculation is not intended to represent the past or future performance of any investment.






Inflation

Inflation-Adjusted Income and Asset Analysis


Inflation occurs when it costs more to buy goods and services than it did before. More technically, inflation is a rise in the prices of goods and services. The inflation rate is the rate of change in prices.

A primary indicator of the inflation rate in the United States is the Consumer Price Index which tracks changes in prices paid by consumers. Similar measures such as the Producer Price Index measure inflation as it affects suppliers of goods and services.






Inflation

Income Due to an Investment Fund


Inflation occurs when it costs more to buy goods and services than it did before. More technically, inflation is a rise in the prices of goods and services. The inflation rate is the rate of change in prices.

A primary indicator of the inflation rate in the United States is the Consumer Price Index that tracks changes in prices paid by consumers. Similar measures such as the Producer Price Index measure inflation as it affects suppliers of goods and services.

Individual Retirement Accounts (IRAs) and other tax-deferred retirement funds may be able to provide a larger income for a longer period of time if the initial earnings are more than is needed to provide the desired after-tax income because the excess earnings can be accumulated and reinvested without any current tax on those retained earnings.





Inflation

College Cost Estimator


In trying to estimate future college costs and the rate of savings that will be needed to pay those costs, several factors will need to be considered:


1. College costs can vary greatly among different types of institutions, with four-year private colleges and universities usually costing more than twice what is charged state residents by public four-year colleges.


2. Inflation in college costs has been generally higher than inflation in other kinds of prices over the last thirty to forty years, and annual increases of at least 5% to 7% seems to be the rule and not the exception. However, the rates of inflation have also varied by the type of institutions, with costs at private colleges and universities generally increasing faster than costs at public schools.

3. The published costs can be much higher than what students actually pay, due to the availability of grants, scholarships, and other forms of student aid, all of which can vary greatly from school to school and may increase or decrease over time.

Current information on college costs and trends can be found on the website of the College Board (www.collegeboard.com).






Inflation

Lump Sum Needed for Increasing Annuity


One of the most important time value calculations available to the financial planner is the "growing annuity." Using this mathematical concept, it is possible to compute the present value of a growing annuity.

For example, your client wants to provide his wife, in the event of his death, with income possessing the purchasing power of $50,000 each year for the next 20 years. The problem is that inflation will diminish the purchasing power of a fixed annual income. Therefore, to keep purchasing power up to the $50,000 a year level, the fund must be able to generate more than $50,000. Assume that the client feels inflation will average five percent per year, and the fund itself will be able to earn an after-tax return of seven percent. How much life insurance should the client purchase today, assuming that the face amount of the policy is paid to the wife in a lump sum? The necessary face amount is $785,844.

Two other situations that call for the use of this same calculation are college funding and retirement funding. For instance, suppose a client wants to accumulate a lump sum that will pay $10,000 in the first year of college. He expects education costs will increase five percent each year for the following three years. Also, he feels whatever fund he creates can earn a net return of seven percent. The calculation indicates he needs a beginning balance of $36,348.

An example of retirement planning would be similar to the first example. If a retiring client wished to have investment income of $50,000 annually, which would increase by five percent each year for twenty years, they would need an initial capital of $785,844 earning a seven percent after-tax return.






Inflation

Contributions Required to Reach a Goal


Among the most important time value calculations available to the financial planner is the "growing annuity." Through this mathematical concept, it is possible to determine how much a client will have in a fund at the end of each year, if he earns more than a given rate on his investment or he increases the level of his investment each year.

For example, your client wants to accumulate $100,000 over ten years to send his eight year old twin daughters to college. He feels confident he can earn a seven-percent rate of return (after taxes). Based on past pay raises, he also believes that he will be able to increase his contributions by the same percentage as his annual pay increases six percent each year. Using this steady return of an annually increasing contribution, he'll only need to start with $5,672. If he earns seven percent on the invested funds, and increases each succeeding annual contribution by just six percent, he'll reach his $100,000 goal on time.

Representatives should caution clients to express the target amount ($100,000 in the example above) in terms of future rather than present dollars. In other words, if the client feels he needs $100,000 based on the purchasing power of today's dollars, but also expects inflation between now and then to increase college costs by seven percent per year, the target should not be $100,000 but rather $196,715. This is determined by calculating the future value of $100,000 in ten years at seven percent. (The Future Value of a Lump Sum calculation can be used to calculate this figure.)

Retirement planning also requires an understanding of the growing annuity concept. For instance, assume your client is a participant in a 401(k) plan. Contributions on her behalf are based on a percentage of her salary. If she contributes six percent of her current salary, and her employer matches that amount 50 cents for every dollar, how much will she have when she retires (Factoring in 402(g) limits to deferrals if applicable). If you expect her salary to increase each year by some constant rate, both the employee's and the employer's contributions are forms of growing annuities to the fund. If there is currently a balance in the plan account, the future value of that account must be computed separately using the Future calculation (from the Estate Planning Tools) with that result added to the future value computed for the growing annuity.






Real Estate

After-Tax Return on an Investment


Representatives must have a great deal of information in order to compare one investment to another, or to judge the relative performance of an investment from one year to the next or over a period of time, or to make "buy" or "sell" decisions.

Here are four major criteria used when making these decisions:

  1. The net cash flow from the investment. This is extremely important for cash flow management purposes. If the client is not able to realize sufficient net cash from an investment, he or she may not be able to make interest payments on the investment or pay other related expenses. Even if an investment has a rate of return superior to an alternative, the level of net cash flow may be the deciding factor as to which investment should be selected.

  2. The after-tax return on the investment. In comparing investments, planners often overlook the fact that a client's wealth or income should only be measured in terms of "the bottom line." A comparison of investments should always take into account how much the client will have left after payment of income taxes.

  3. The rate of return on investment. Other things being equal, a client should select the investment that produces the highest rate of return. No investment should be made if the rate of return on the investment is below acceptable levels or negative.

  4. The rate of return on equity. This may be the best gauge of an investment since the overall rate of return may significantly understate the true value of an investment which provides a positive after-tax cash return and is leveraged. This percentage illustrates the power realized by an investor who wisely uses borrowed money to compound the return on his own.




Real Estate

Amortization Schedule


Mortgage amortization involves the periodic reduction of a mortgage debt over periods of time typically ranging from 10 to 30 years. Interest rates are applied only to the remaining balance on the mortgage debt. Principal and interest are included in monthly payments, which may also include escrowed amounts for real estate taxes, insurance, and other assessment items against the property.

The mechanics of an amortized loan are that the lender calculates the exact amount that must be paid each month (or quarterly, semiannually, etc.) in order to completely amortize (pay off) the principal amount of the loan over the specified time period.

The amortization process continues until the loan is paid off. During this time, the annual interest is first computed on the remaining balance of the mortgage. Then, it is converted to a monthly interest charge by dividing the annual interest by 12 months. This monthly interest is then subtracted from the payment. The balance of the payment remaining is then deducted from the remaining mortgage balance. The result is the new mortgage balance. This is then used to compute the next month's apportionment and charges.

Since the loan balance is larger in the early years, a much larger portion of each payment goes to interest. In later years the greater portion of each payment is credited against principal.





Real Estate

Break-Even Period Refinancing


mortgage interest rates decline, refinancing (borrowing new money to pay off old debts) may be advantageous. Refinancing may make sense regardless of whether the mortgage is a conventional fixed-rate mortgage or adjustable with monthly payments rising and falling with market rates. Lower fixed rates do lock in smaller payments but total costs should be considered before refinancing.

In the case of fixed-rate mortgages, refinancing should be considered when an interest rate is at least two percentage points below the current rate being paid. This two-point spread is usually the minimum needed to offset refinancing charges.

Refinancing costs include the following items:

  1. new title search and title insurance

  2. New mortgage loan origination fees (usually 1% of the loan amount)

  3. "Points," the current fee charged by lenders for mortgage loans (one point equals one percent)

  4. Recording fees

  5. Notary fees

  6. Distribution fees for title company

  7. Application and sometimes commitment fees for mortgage company

  8. Appraisal fees

  9. Credit report

  10. Possible termite certification

  11. Possible attorney's fees

  12. Possible survey fees

  13. Possible document preparation fees

The necessary spread increases as the length of time the property will be owned decreases. In other words, a wider spread than two points may be needed if the property will be held only a short period of time. This is because it takes time for lower payments to offset the significant cost of refinancing. Prepayment penalties (illegal in some states) will also increase costs, and therefore increase the spread necessary to make refinancing worthwhile.

Computations must take into consideration the impact of income taxes, and deductions for mortgage interest must be factored into the calculations.

"Recasting," a concept popularized by Realtor and radio commentator Russell E. Miller, is an alternative for some homeowners. Recasting reduces the interest rate and therefore the monthly payments, but instead of practically starting from scratch, recasting requires only that the present mortgage "note" is modified and that a new settlement is not required. The catch is that the mortgage must still be held in the lender's investment portfolio, the mortgage must be a direct reduction conventional type loan, and the lender must agree to the recasting.






Real Estate

Mortgage Comparison Schedule


Before borrowing to finance, it is imperative that a consumer or investor understands the extent of financial responsibility. Furthermore, "shopping for a loan" reveals stark differences in cost and terms of loans.

For example, a $150,000 loan at 10 percent interest could be repaid over a 30-year period with monthly payments of principal and interest of $1,316.36. Total interest paid on the loan would be $323,890, and the total repayment costs would be $473,890. The same loan at 9 percent would require monthly payments of $1,206.93. Total interest would amount to $284,495 and the total repayment would be $434,495. At 11 percent the same loan would require $1,428.49 monthly payments. Total interest would be $364,256 and the total payments would amount to $514,256.






Real Estate

Double Payments on Retirement of a Mortgage


Managing installment debt is one of the most complex elements of personal financial planning. Consumer borrowing, from the wise use of credit cards to installment loans, to a home mortgage, plays a significant role in the financial affairs of almost every individual or family. For younger persons it can be more crucial than any investment decisions they might make.

Despite this importance, however, most consumers do not focus enough attention or analysis on their borrowing decisions. Most borrowers simply "shop their loan" for the lowest available rate and generally accept the terms offered by their local lending institutions. Consumers also tend to be somewhat shortsighted in looking for the lowest monthly payment rather than examining the overall cost of the financing.

Even after a loan agreement or mortgage has been put in place, the borrower may benefit enormously by paying more than the regular payment amount. Most installment and mortgage loans allow advance payments or prepayments to be made without any penalty.

One common approach to paying off a home mortgage is to pay double the amount of principal that is due with each payment. This is generally not too burdensome for borrowers during the early periods of the loan since the amount of principal paid with each payment is quite small. It may become more challenging toward the end of the loan period when the principal portion of each payment grows rapidly.

The result of this technique is to effectively cut the borrowing period in half with a corresponding reduction in the interest cost of the loan. The default case shown in the program is for a 30-year, $100,000 mortgage at an interest rate of 7%. If the borrower were to make the standard 360 monthly payments of $665.30 each, interest costs of $139,510.98 would be added to the original principal of $100,000 for a total repayment of $239,510.98. However, if the borrower, each month, were to pay the principal and interest due for that month, plus the principal due for the next month, the overall results would be quite different. Using this technique, the loan would be repaid in 15 years rather than 30, and the total interest cost would be $69,900.87 instead of $139,510.98. Thus, there would be an interest savings of $69,610.11.

Should an individual adopt this technique? The answer will depend on a number of considerations both current and future. Among these are current income, expected future income growth, tax considerations (future interest deductions will be reduced), and other investment opportunities. There may also be an emotional benefit from paying off a mortgage in a shorter period of time. Financial planners should discuss all of these factors with their clients in order to help them make the most effective borrowing decisions.






Real Estate

Break-Even Interest Rate Comparison


In making any major investment, especially in real estate, financing options must be considered. Investors must decide how much capital to invest, how much can or should be borrowed, what sources of borrowing are available, and what the cost of borrowing would be. Such decisions affect the net cash flow from the investment, its overall profitability, and the rate of return on the capital.

Taxes are important considerations since investment interest payments are deductible, up to certain limits, for income tax purposes. Tax deductibility often makes borrowing a more attractive approach than equity funding because dividends paid to equity investors are not tax deductible. In contrast, dividends paid to equity investors are not tax deductible.

The tax deductibility of interest payments often makes borrowing to finance an investment, referred to as "financial leverage," a more attractive approach than equity funding. However the risk of default on the debt payments, interest and repayment of principal, adds to the overall risk of the project.

Borrowing to finance a project will be attractive as long as the after-tax interest cost of debt is lower than the rate of return on the project. After this point has been reached, equity financing is more attractive.






Real Estate

Mortgage Payment Calculator


Before borrowing to finance, it is imperative that consumers or investors understand the extent of financial responsibility. "Shopping for a loan" reveals significant differences in both cost and terms for the same amount of borrowing.

For example, a $60,000 loan at 12% interest could be repaid 30-years with monthly payments of principal and interest of $617.17. The same loan at 13% interest requires monthly payments of $663.72. The difference in loan payments over a 30-year period would be $16,758.






Real Estate

Loan Payments


The amount of each payment on a loan, and how much of each payment is interest or principal, depends not only on the principal amount of the loan, the interest rate, and the term (duration) of the loan, but also the payment frequency (monthly, quarterly, semiannually, or annually) and whether the loan is amortized, level principal, or interest-only.


In an amortized loan, the payments are calculated so that the periodic payments of combined interest and principal are equal amounts over the term of the loan. The interest is always calculated on the principal balance owed, but the interest amount goes down (and the principal amount goes up) as the principal of the loan is paid. So, early in the loan, the payments will be mostly income with very little principal paid, while towards the end of the loan the payments will be mostly principal with very little interest payable on the declining loan balance.


In a level-principal loan, the principal payment is fixed as the amount needed to pay off the principal amount over the stated term, and if there is no “balloon” payment, then the principal portion of each loan payment will be the principal amount of the loan divided by the number of payments to be made. The interest portion of each payment is calculated on the principal balance remaining, so the interest amount goes down as the principal of the loan is paid. Because the principal portion of each payment is a fixed amount, and the interest portion goes down over the course of the loan, each loan payment will be different, and the payments will go down over the term of the loan.


In an interest-only loan, no principal is paid until the end of the term. Because the principal of the loan remains the same throughout the term, the interest payments also remain the same.


A compromise between an interest-only loan and an amortized or level-principal loan is a loan in which some principal is paid during the term and the balance is paid as a “balloon” at the end of the term. So, for example, the periodic payments on a loan can be calculated based on an amortization over 30 years even though the term of the loan is only 15 years, in which case the balance of the principal is payable as a lump sum “balloon” at the end of the 15 years. A level-principal loan can also be calculated with a principal-recovery period that is longer than the actual term of the loan, also resulting in a balloon payment at the end of the term.


The “annual percentage rate” or “APR” is a useful number to know in comparing the true costs of different kinds of loans, and the APR is not necessarily the same as the interest rate used to calculate the loan payments. If the payments are monthly, quarterly, or semiannual, the APR will not be the same as the interest rate that is entered for the note because payments that are more frequent than annual have the effect of compounding the interest rate, so the APR (or effective interest rate) is higher.






Insurance

Rate of Return on Life Insurance


The actual interest credited to a life insurance policy normally exceeds the statutory guaranteed interest rate, typically in the range of three to six percent. Policy duration has a significant effect on actual interest earned; the longer the policy stays in force, the higher the actual credited rate.

The calculation process requires you to know six factors:

1. The cost for the amount of current protection (usually a competitive term insurance rate per thousand dollars of coverage at the attained age of the insured). (Term Rate)

2. The premium amount. (Premium)

3. The dividends paid for the year. (Div)

4. The current cash value. (Face)

5. The cash value one year ago. (Prior CV)

6. The face amount of coverage. (Face)


Following is the formula used to find the rate of return:

Rate of Return = {[(cv + div) + term rate x (face - cv) x (.001)] / (premium + prior cv)} - 1

There is a direct correlation under this formula between the term rate assumed and the rate of return; the higher the term rate, the higher the rate of return.

Taxes are not taken into consideration in this equation. The resulting rate of return is based on a before-tax internal buildup of cash values and should therefore be compared with tax-free bond yields.






Insurance

Net Cost of Life Insurance


Life insurance costs are typically calculated in terms of the price per thousand dollars of coverage. To compare two or more policies, it is important to be able to equate each policy payment to be the cost per thousand dollars of protection.

It is easy to compute the cost per thousand of term insurance. Divide total cost per year by the number of thousands of dollars of coverage. For instance, if the policy provides $120,000 of coverage, there would be 120 units of coverage. If the premium (including any policy fee) is $280, then the cost per thousand of coverage would be $280 / 120 = $2.33.

Whole life presents a more complicated problem. The problem stems from the fact that policy cash value is involved. An "opportunity cost" is incurred. That is, the cash values, if not "invested" in the whole life contract, could have been put to work elsewhere. Stated in a slightly different manner, the policyholder has allowed someone else (the insurer) to use the money and has deferred personal use until a later date. It is necessary to factor in a "discount" (interest) rate to reflect a conservative after-tax rate of return that (over a long period of time) could have been earned on the money had it not been "loaned" to the insurer.

Current cash value, a key number in the equation, is found in the policy cash value chart. The current cash value is based on the age of the insured person at the time the policy was purchased and the length of time the policy premiums have been paid. The increase in cash value is the difference between last year and this year's cash value. This number can be obtained from the insurer.

Dividends paid on "participating" (mutual) policies must be considered in computing net cost. Dividends can be considered either by appropriately reducing the premium or by increasing the cash value.






Insurance

Net Clear Death Benefit


The net clear death benefit is the amount of policy proceeds payable upon the death of the insured, minus the accumulated after-tax outlay at interest. It shows the excess proceeds over and above the client's outlay with a cost of money factor added in.

For example, a 45-year old client wants to purchase a universal life insurance policy. He wants to pay ten level premiums, have a death benefit of $100,000 plus the cash value until age 65, and then switch to a level death benefit. His expected age of death is 83. The accumulated premium plus interest at 6.5% is $79,171. The death benefit payable is $131,928, yielding a net clear death benefit of $52,757.

It can also be likened to a net present value calculation. If the client accumulates the out of pocket cost at a rate of 6.5%, he would have $89,798. The policy provides a gain of $42,130. As an investment, the client has met the goal of growth at 6.5% plus a gain of the net clear death benefit.






Insurance

Insurance Needs Analysis


There is no perfect answer to the question of "How much life insurance do you need?" Ultimately, the answer must be, "I don't need any life insurance - but those I love do." So how much do they need? There are two basic approaches, the "human life value" approach and the "capital needs" approach.

The human life value approach evaluates the economic worth of a person to those who are dependent on his or her ability to generate income. Essentially, it assumes death occurs today and measures the economic loss that would have been generated had the individual lived to the end of his or her working lifetime.

The needs approach (some call it the programming approach) analyzes various expenses that must be met if the income provider dies. These needs will vary depending on the composition of the surviving family, their current living standard, and the standard to which they are assumed to adjust.

Capital to pay lump-sum outlays such as illness expenses, burial costs, and estate administration expenses is essential.

Re-adjustment or transition income that serves as an economic shock absorber allows families to adjust to the death of the breadwinner. Although not essential in absolute terms, this extra income/capital can be of tremendous psychological comfort.

Income for the family while the children are dependent (often called the "dependency period") is another essential.

Special needs for capital or income must be considered. These "special needs" include cash to pay off a mortgage (good to have even if you don't actually use it for this purpose), an "emergency fund," educational needs, or other special needs such as a handicapped parent or retarded child.

After needs are identified and translated into terms of income and/or capital, it is important to determine sources and amounts of currently available cash. The difference between what is now available and what is needed represents the additional life insurance that should be purchased.

It is important to note that there are weaknesses in both the human life value and the needs approach to the problem. But these flaws are minor. No survivor ever complained that the insured had too much life insurance! Survivors must be protected before they are survivors, or they must learn to live with less or live without.

Consider printing out a number of different assumptions and constructing a "survival level-flourish level" spectrum of insurance needs. Then choose the one that is most affordable from a premium payment viewpoint and from the position of the potential survivors.






Insurance

Total Cost of Group Term Life Insurance


Group life insurance generates a tax cost. The covered employee must report this cost as income. The cost is figured in the IRS's Table I.

Generally, the cost of coverage in excess of $50,000 is taxable. But if the employee contributes to the cost of insurance, the entire contribution (for coverage up to $50,000 and for excess coverage) is allocable to coverage in excess of $50,000. This means each dollar contributed by the employee offsets an otherwise taxable dollar (no carryovers allowed). Key employees are not eligible for this $50,000 exclusion if the group term plan works in their favor.

Reportable costs increase in five-year bands until they stabilize at age 64. The annual after-tax costs can be surprisingly high. The results should be compared with the cost of individual coverage. In many cases, individual coverage through a competitive product will be less expensive.






Insurance

Business Buyout Analyzer


program calculates the cost of an installment purchase as an alternative to funding a buy-sell agreement with life insurance. It shows the total premium outlay to fully fund the buy-sell compared with the profits needed if there is no insurance. This assumes that the business or the surviving shareholders buy out a decedent's stock over a period of years in the form of installment payments. It shows the gross amount of sales necessary, at the firm's profit margin, to equal the after-tax profits to pay each installment plus interest.

There are many drawbacks to the installment method of paying for a deceased co-owner's business interest:

  1. The installment method may not provide the large amounts of cash needed by the client's family to pay federal and state death taxes and other estate settlement costs.

  2. The financial security of the decedent's family remains tied to the business.

  3. The cost will be incredibly high, even if interest on the unpaid balance is deductible (it probably will not be in some cases).

It is essential that a client understand the true cost of a non-insured buy-out. For example, assume the purchase of a $1,000,000 business interest including ten annual principal payments of $100,000 a year, plus interest on the unpaid balance at 10 percent. If the business buys the decedent's stock, is in a 34 percent tax bracket, and enjoys a 20 percent profit margin, the business will have to earn $2,065,150 in profits and $10,325,750 in sales!






Insurance

Need for Business Interruption Insurance


Business interruption insurance, often called "use and occupancy" insurance, protects against the loss of income because of the interruption of business when damage to property is caused by specified perils.

The insuring agreement of a business interruption policy states that the policy covers loss resulting directly from interruptions of business caused by damage to or destruction of real or personal property by the insured peril(s). The loss is the reduction in the flow of earnings to the business.

The actual loss of earnings is essentially the reduction in gross income that the firm would have received had no interruption occurred. This means that to determine the actual loss sustained it is necessary to deduct the non-continuing expenses of the business. Reimbursement would continue until the damaged property is restored or could have been restored with due diligence and dispatch.

How large is the potential loss a closely held business might incur? It is necessary first to determine the amount of expenses that would not continue during interrupted operations. These non-continuing expenses are subtracted from the business' projected gross income. Discounts and allowances are common revenue reductions. Certain employees can be laid off but the salaries of others may have to be continued.

Most firms should periodically reappraise the loss in profits that would occur in the event of a business interruption, and assess the amount of business interruption insurance (or alternatives) that should be carried.






Insurance

Death Benefit Rate of Return


Although life insurance is usually purchased as protection against an untimely death, and not as an investment, the benefit that is payable upon the death of the insured can be analyzed like the return on an investment, and this analysis can be helpful in comparing different life insurance policies with different premiums and different death benefits.

The rate of return on the death benefit can be calculated by treating the premiums that are paid as though they were investments in a contract, and treating the death benefit as though it were the return on an investment at maturity.

The most important factor in calculating the rate of return will be the date of death. If death occurs shortly after the policy is purchased and before many premiums are paid, the death benefit will be extremely large compared to the total premiums paid and the rate of return will be extremely large. But if death occurs only after many years, a large number of premiums will have been paid and a significant amount of time will have passed within which those premiums could have been invested to produce the funds needed to pay the death benefit, and so the rate of return will be much smaller.

Of course, the date of death will not be known when the policy is purchased, and so a calculation of rates of returns on the death benefit should show a range of different numbers of years that might elapse before death occurs.

This calculation is most meaningful for whole life, universal life, and other forms of “permanent” insurance, and is less useful for term insurance.





Net Worth

Net Worth Analysis and Evaluator


Net worth is the most comprehensive statistic that can be used in measuring the financial position of an individual, family, or business. It takes into account all assets, both short-term and long-term, as well as the liabilities that are claims against those assets. Presumably, it shows the amount of money that would be available if all assets were liquidated, and all liabilities paid off, though this is a very unlikely occurrence.

An accurate net worth calculation depends on a careful valuation of all assets, especially personal assets most financial assets, such as savings accounts, certificates, stocks, and bonds. Similarly, liabilities are easy to measure since they are generally represented by some obligation such as a mortgage, bank loan, or account balance. More difficult is placing a value on a home, furnishings, clothing, and other personal possessions such as antiques or collections. Often the value of these can only be estimated or valued through an expert appraisal.

Projecting net worth compounds estimated growth rates over future time periods. Conservative estimates should be used, and it is recommended that time periods not be longer than ten years. A yearly review of actual results should be carried out to see if past estimates have been accurate and to update growth rates according to current economic conditions.






Net Worth

Security Portfolio Analyzer


Portfolio analysis seeks to match investment objectives and risk-taking propensity with securities owned. An efficient portfolio provides a mix of securities that affords the highest possible total return (income and growth) consistent with these two key factors and after consideration of the impact of taxes and inflation.

For the astute investor, selection and purchase of appropriate securities is only a beginning step. Implementation and monitoring of the investment policy depends to a great degree on the ability to summarize and update key facts. This template enables you to record and update much of the information essential to personal investment management.






Net Worth

Taxable Social Security Benefits Under OBRA '93


The Omnibus Budget Reconciliation Act of 1993 (OBRA '93) greatly affected the rules regarding social security benefits. Starting in 1994, taxpayers may be taxed on up to 85% of their social security benefits. Under the prior law, social security recipients were taxed on up to 50% of their benefits.

The law applies to taxpayers whose Provisional Income (Adjusted Gross Income, or AGI, excluding social security benefits, plus tax-exempt interest income and 50% of social security benefits) is greater than $44,000 (married filing jointly) or $34,000 (single). For those falling into this income bracket, the amount subject to taxation is the lesser of 85% of social security benefits or 85% of the amount of the taxpayer's provisional income over the OBRA '93 amounts ($44,000/$34,000), plus the lesser of $6,000 (married filing jointly) or $4,500 (single), or the amount subject to taxation under the prior law 50% inclusion rules.






Net Worth

Periodic Withdrawals from an Investment


It is often necessary to compute how much could be withdrawn at given intervals from a fund earning interest at a certain rate for a specified period. For instance, a person who has just retired may have saved $60,000. His life expectancy is 10 years and he feels that he could easily earn (net after taxes) 9 percent on his money. He wants to know how much he could withdraw each year so that at the end of the 10 years, he will have exhausted his fund.

An alternative use for the same calculation is the amortization of a loan. You have a $30,000 loan for 10 years at nine percent. How much is each payment you must make?

Stated another way, assume you have loaned $30,000 for 10 years at 9 percent. How much will you be paid each year?

To compute the amount of cash you must invest at the beginning of a specified period, if you assume you will be making withdrawals of a given amount, use the "present value of an annuity" program.






Net Worth

How Compounding Builds Net Worth


The future value of a lump sum equals the growth of that lump sum over a designated period of time. The date of the original investment (or the current date in the case of projecting the growth in a client's estate) marks the beginning of the investment period. Computations assume that no additional investments will be made, that no funds will be withdrawn for the entire time, and that the assumed rate of return will be constant over the selected period.






Net Worth

Future Value of Increasing Payments


An increasingly useful "time value of money" calculation is the growing annuity. Using this approach, it is possible to determine how much a client will have in a fund at the end of each year, if he: increases the level of his investment each year and earns a given rate of return on his investment.

For example, your client wants to begin accumulating capital for retirement over the next twenty years. She will make an initial year-end contribution of $2,000 and feels confident she can earn, after taxes, a six-percent rate of return. She is also committed to increasing her contributions by five percent each year. Her contributions and earnings will total $110,768 at the end of twenty years.

Representatives should remind their clients that the resulting amount is in terms of future rather than present dollars. In other words, the client may accumulate $110,768, but those funds will not have the same value (purchasing power) in the future as they would have today. For example, assuming a five-percent rate of inflation over twenty years, the present value of $110,768 is only $41,747.






Financial Goals

Summary of Financial Objectives


The most important step in turning dreams into reality through goal identification is stating objectives in financial terms. Quantifying goals using the "time value of money" has two effects.

First, the process must reflect the negative effects of inflation on funding future goals. One dollar of cost today will equal two dollars in twelve years if inflation takes place at six percent annually.

Second, funds invested today have the benefit of future growth, and larger sums will be available in the future, especially if sheltered from income taxes.

Inflation-adjusted time value calculations show the dollar amount needed now or on an annual basis to reach targeted objectives.






Financial Goals

Accumulation Planning Worksheet


The major difference between a goal and a dream is quantification. The desire for a "comfortable retirement" or "adequate financial security" is a dream; the desire for a specific amount of capital at a specific target date is a goal. That goal will be met by most people only if sub-goals are devised such as "to have $100,000 on hand in Z years, I must invest a lump sum of $X today or invest $Y each year."






Financial Goals

Educational Funding Analysis


The average annual cost of tuition, room, and board, for both public and private institutions, has grown quickly over the years. This trend is likely to continue. So early planning, to take education costs into account, is the best way to minimize the overall effects on your family budget.






Financial Goals

Retirement Analysis


The task of providing adequate income at retirement should be divided into three parts:

1. Income from governmental retirement plans.

2. Income from employer-based retirement plans.

3. Income from personal assets.


Taxation and inflation are two factors that must be considered in planning financial independence at retirement. It is therefore important to begin with a "Desired Monthly Income," which considers both inflation and taxation during retirement years.

During our working years most of us can depend on regular wage and salary increases to keep up with inflation. Once retired, however, many income sources will become fixed in amount and be subject to a loss of purchasing power over time. This calculation allows you the option to build in an annual increase in desired income after retirement. The resulting capital need is increased, but the impact on a client's financial planning will be more realistic.

Retirement security must not depend on governmental or employer-based programs; social security should at best be thought of as a guaranteed income floor, and employer-sponsored programs have often failed due to inadequate funding. An individual can only rely on an adequate capital sum amassed through a disciplined, diversified, and long-term personal investment program.






Financial Goals

Social Security Benefits


Significant benefits are payable to the survivors of a deceased insured worker:

Monthly benefits may be payable to a surviving spouse as mother's or father's benefits. This payment is made to the widow or widower regardless of age, assuming that the person is caring for at least one child who is under age 16 or who was disabled prior to age 22. Note that benefits for children age 18-22 who attend college or post secondary school were completely phased out in April 1985.

  1. A child's benefit is payable monthly for each child who is under age 18 and for children over age 18 who were disabled prior to age 22.

  2. A widow(er) benefit is payable monthly to the surviving spouse (or surviving divorced spouse) of an insured worker when the survivor is age 60 or older.

  3. A disabled widow(er) benefit is payable monthly for disable surviving soused ages 50 to 60.


Up to one half of the social security benefit received by taxpayers whose incomes exceed certain base amounts is subject to income taxation.






Financial Goals

Present Value of Future Retirement Benefits


Representatives are often faced with valuing assets that are not presently in hand, but will be available at some future date. Life insurance proceeds are examples that are fairly direct, where expected amounts are known with certainty. Another more complicated situation involves estimating the present value of monthly pension benefits to be received during some future retirement period. The need to value these benefits commonly occurs in divorce cases and other financial planning situations.

Determining the present value of future retirement benefits is complex due to the uncertainty of survival to the retirement period, the unknown number of monthly payments to be received, interest rate variations over these periods, and the taxes that have to be paid once these benefits are received. Combining all of these estimates to obtain a single present value is admittedly guesswork, but by varying the inputs, a representative can obtain a decent estimate of the current value of future pension payments.






Financial Goals

Federal Estate Tax Discount


Federal estate taxes were designed to be extremely progressive for the purpose of redistributing wealth. Rates in 1987 and later range as high as 50 percent. Yet it is possible to pay these taxes (and other estate settlement expenses) at a "discount" through judiciously arranged life insurance.

Life insurance, if owned by a third party who is also the beneficiary, has a number of advantages. It is:

  1. Income tax free.

  2. Estate tax free if death occurs more than three years after any actual or constructive transfer of the policy by the insured.

  3. State inheritance tax free.

  4. Probate cost free.

  5. Not subject to administrative or transfer charges.


These factors alone would make life insurance a favored vehicle for the payment of the federal estate tax.

In addition to the fact that the modest estate owner can use life insurance to create an "instant estate," it has another important advantage. Life insurance is purchased on the "self canceling debt installment plan." In essence paying premiums on life insurance can provide, in advance, full payment of many debts, including federal estate tax. At the death of the insured, even though the premiums stop, the proceeds (and therefore the debt) can be paid.

Consider the amount of the "discount" when only a few premiums have been paid before the insured's death. Even if many years' premiums have been paid, the payment of the proceeds is payment of the estate tax (and many other costs) at a discount.






Budgeting

Income and Expenses Report


Budgeting can be defined as the ability to estimate the amount of money to be received and spent for various purposes within a given time frame. From a planning perspective, budgeting is a deliberate program for spending and investing available resources. It is both the starting point for financial planning and the yardstick against which actual investment results can be measured.

Budgeting starts with a working budget model, in essence a financial "X-ray" of what is occurring now. This is accomplished by summarizing income sources, listing expenditure categories, and breaking down various sources of income by percentages.

Expenses should be subdivided into "fixed" and "discretionary" expenses. Fixed expenses are essential and not significantly reduced without an uncomfortable change in living standard. Discretionary expenses may be eliminated or curtailed within a relatively short period of time. Both types of expenses must be totaled and shown as percentages in order to illustrate "where the money is going."

The final step is to compare total annual income and expenditures to determine net saving or net borrowing in terms of both dollars and a percentage.

Once the mathematics are completed and analyzed, pragmatic approaches must be found to increase income, decrease spending, or both in order to increase financial security through additional (or more appropriate) investments.

Consider three printouts, one based on the way things are now, the second on a "lowest potential income-highest likely expenditure" situation, and a third on a "highest likely potential income-lowest likely expenditure" situation.






Budgeting

Monthly Cash Flow Report


Aside from a balance sheet, the most important document necessary for financial planning is a statement of income and expenditures. This is essential to assess the present economic health of a client, to determine the extent of any excess discretionary income available for investing, and to control the timing of income and outgo.

Proper planning requires that you use comparative income and expense statements as a tool to determine the following items:

  1. stability, reliability, and predictably of income and expenses.

  2. The potential for income growth.

  3. The relationship between income and lifestyle. For example, does income flow match standard of living?

  4. The relationship between income and investment accumulation. For example, how long has the present income level been maintained and has the level of investment risen with income growth?

We tend to forget the level and nature of our expenses. Consider which expenses are "excessive" and the extent to which the present levels of outlays have mortgages the future.

Timing is as important as tracking the amount and nature of income and expenditures. Although it is impossible (and unnecessary) to follow every dollar, it is essential that the timing of major sources of income and expense be recorded so that cash flow management can be aligned with personal objectives.






Budgeting

Dividend and Interest Income Report


Common stock represents an equity position in a corporation. Stockholders are entitled to a proportionate share of the corporation's "C/P/A," that is, Control (through voting rights), Profits (through dividends), and Assets upon a sale or liquidation.

The size of a corporation's dividend is based primarily upon two factors: the earnings of the corporation and the firm's need (or the shareholders' desire) to retain and reinvest some portion of profits in company operations. Publicly traded corporations usually pay out a significant portion of each year's earnings, while closely held corporations typically retain a higher percentage to shield shareholders from double taxation.

Dividends may be paid in cash or in stock. When a stock dividend is paid, investors physically receive more shares based on a percentage of the stock they own. This means an investor with 100 shares of stock in a company will have 112 if there is a 12 percent stock dividend. Funds from the corporation's retained earnings account are then transferred from retained earnings to the capital stock account.

Dividends are fixed on the "date of record" and are then paid only to those who owned stock on that date. The day following the date of record is called the "ex-dividend" day. Starting on the ex-dividend day, the stock trades without the dividend, and the stock's price will often drop by the amount of the dividend. Actual payment of a dividend is sometimes weeks after the date of record.

No dividends may be paid on common stock in any year or cumulative years in which the full dividend has not been paid on preferred shares.

Debt securities can be found in two general forms: short term and long term. Short-term debt issued by corporations in the form of "commercial paper" and is sold at a discount from its face value. Upon maturity, investors receive the full face value amount. Most commercial paper matures in less than nine months. CDs, certificates of deposit, are another commonly owned type of short-term debt. These are deposit liabilities of a bank or savings and loan. CDs often mature in less than a year and differ from commercial paper because they are interest bearing and not sold at a discount.

Bonds represent the long-term debt of corporations. They generally pay interest semiannually and repay the principal at a predesignated date, from 5 to 30 years from issuance.






Budgeting

Term of Loan Calculator


Consumer borrowing has become one of the most important dimensions of personal financial planning. Using credit wisely can be just as important to an individual's financial security as saving for retirement or having the right insurance coverage. Evaluating credit terms can be a complex problem involving the amount borrowed, the interest rate to be paid, and the term of the loan.

Representatives can assist clients with their borrowing decisions by analyzing the effect of making larger or smaller payments on a loan. Generally, making even slightly larger payments can shorten the term of the loan and substantially reduce the total interest paid on the loan.






Budgeting

After-Tax Return and Cost Calculator


The term "marginal tax bracket" means the tax rate that is multiplied by the taxable income in excess of income taxed at the next lowest bracket. The term, "combined marginal tax bracket" is the highest rate on which taxes are collected. It is important to remember that this includes not only federal taxes but also state income taxes as well.

Assuming a deduction is allowed against the federal income tax for state income taxes paid, the following formula is used to find the combined federal and state marginal bracket:

CMTB = F + S (100% -F)

Where:

CMTB = Combined Marginal Tax Bracket
F = Federal Tax Bracket
S = State Tax Bracket

To calculate the CMTB of individuals who do not itemize their deductions, add the federal bracket and the state bracket together.

Knowledge of the combined marginal tax bracket is essential in realistically appraising either the true return on an investment or the net cost of borrowing for investment purposes. This concept is basic to financial analysis. For instance, if an individual has a combined federal and state bracket of 34%, and 10% before-tax return on investment equates to an after-tax return of 6.6%.

The same principle applies to the extent the interest paid on an investment can be compared with the after-tax cost of financing that asset, it is easier to decide whether or not to borrow money to finance the investment or even to make the investment at all. Obviously, the greater the spread between the after tax return and the after tax cost, the more likely investment results will be positive.






Budgeting

Cost of an Outlay


For each dollar earned above certain amounts, taxes must be paid by either individuals or corporations. For each dollar deductible by either individuals or corporations, taxes are reduced.

An outlay that is nondeductible requires that the taxpayer earn more than that amount to make the outlay. The true "cost" of the outlay in actual dollars earned, is the amount of the outlay plus the earnings needed to pay the tax attributed to the outlay. For example, suppose a taxpayer was in a combined marginal tax bracket of fifty percent. a $10,000 nondeductible purchase would "cost" $20,000. In other words, the taxpayer would have had to earn $20,000 to pay the tax of $10,000 and have another $10,000 left to make the purchase.

An outlay which is deductible requires that a taxpayer earn less than the amount needed to make the outlay. Why? Because money saved in taxes (that otherwise would have been paid to the federal or state government) is available to defray the cost of the purchase. For example, suppose the taxpayer in the illustration above purchased a deductible item. The cost to a taxpayer in a top combined bracket of 50 percent who purchases a deductible item with a cost of $10,000 is only $5,000. This is because $5,000 in taxes that otherwise would have been paid will not have to be.

Keep in mind that both situations depend on the top rate at which tax will be paid or a deduction will be allowed. This is the CMTB, the combined marginal tax bracket, and considers both federal and state income taxes.






Budgeting

Extra Loan Payment Analyzer


Borrowing money is something that most of us do more than once during our lifetimes. Few of us can buy a home or a car, send our children to college, or take an expensive vacation without borrowing some part of the money to pay for it. Even if other funds are available, borrowing may be financially advantageous once tax and investment factors are considered. Interest charges may be deductible against taxable income, and current investments may provide a very attractive rate of return and should not be liquidated.

Deciding when to borrow, how much, at what interest rate, and from which lender can be a very complex financial decision. So-called "truth-in-lending" laws require banks, savings and loans, finance companies, and other lenders to provide borrowers with essential information on their loans. This information includes the principal amount, the rate of interest charged, the regular periodic payment (normally a monthly payment), and the number of payments required in order to pay off the loan. They are also required to state the total amount of interest that will be paid during the life of the loan.

Frequently borrowers may wish to pay more than the regular payment on their loan. Extra payments during the term of the loan can considerably reduce the total amount of interest paid and will result in paying off the loan sooner than originally scheduled. Even a few extra payments can have a dramatic effect on interest paid and the life of the loan.

Borrowers should determine whether or not they can afford to make extra payments, and if so, when and in what amount. It isn't necessary to make large extra payments in order to have a substantial effect on the loan. A few extra dollars each month, or an occasional extra payment, can be just as important to paying off the loan prior to maturity.