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    Taxation: Bourbon's estate planning; Gemstone's IRS audit

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    I:1-48 Pedro Bourbone is the founder and owner of a highly successful small business and, over the past several years, has accumulated a significant amount of personal wealth. His portfolio of stocks and bonds is worth nearly $5,000,000 and generates income from dividends and interest of nearly $250,000 per year. With his salary from the business and his dividends and interest, Pedro has taxable income of approximately $600,000 per year and is clearly in the top individual marginal tax bracket. Pedro is married and has three children, ages 16, 14, and 12. Neither his wife nor his children are employed and have no income. Pedro has come to you as his CPA to discuss ways to reduce his individual tax liability as well as to discuss the potential estate tax upon his death. You mention the possibility of making gifts each year to his children.

    Explain how annual gifts to his children will reduce both his income during lifetime and his estate tax at death.


    I:1-49 John Gemstone, a wealthy client, has recently been audited by the IRS. The agent has questioned the following deduction items on Mr. Gemstone's tax return for the year under review:
    - A $10,000 loss deduction on the rental of his beach cottage.
    - A $20,000 charitable contribution deduction for the donation of a painting to a local art museum. The agent has questioned whether the painting is overvalued.
    - A $15,000 loss deduction from the operation of a cattle breeding ranch. The agent is concerned that the ranch is not a legitimate business (i.e., is a hobby).

    Your supervisor has requested that you represent Mr. Gemstone in his discussions with the IRS.

    a. What additional questions should you ask Mr. Gemstone in an attempt to substantiate the deductibility of the above items?
    b. What tax research procedures might be applied to build the best possible case for your client?

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    Solution Preview

    I:1-48 Pedro Bourbone

    This problem was written prior to the changes in tax law for 2010 and 2011. Because of the sunset provisions of the Bush administration tax cuts, there was no estate tax at all in 2010. The changes for 2011 allow an exemption of $5,000,000 which would radically change the response for this question.

    It is answered using 2009 tax law which allowed an exemption of 3.5M from the assessment of estate income tax. That means if Pedro were to have died in 2009, his estate would have been taxed on 1.5M (5M - 3.5M). The maximum rate currently is 45% plus any amount that the state of residence might charge. Resident estate taxes vary widely from nothing to lots. At 45%, his estate could have to pay the IRS $675,000.

    Granted this is an over simplification of the reporting process which may be the most complex area of tax law, and is usually closely planned and reviewed by an estate or tax attorney. The plan then is to take steps now to avoid the possible payment of $675,000 later, although we know tax law will change in 2010.

    Pedro should consider gifting funds to his three children. Assuming Pedro's assets are owned by both husband and wife, each can gift $13,000 to each child each year. That would amount to gifts of $78,000 per year (3 children x 13,000 x 2 parents). There is no tax on transfer because the amount falls under the limit of the annual gift exclusion.

    The gift of funds must be irrevocable, meaning the transfer must be made into accounts of the children. There are a number of vehicles available for investment once the funds are in the children's accounts. The plan would be to minimize current tax in terms of dollar amounts and the percentage rate of tax. Because the children are all minors, the investment decisions can be made by the parents provided none of the funds come back to the parents. Expenditures of funds for and on behalf of the children are perfectly acceptable including educational costs, for example.

    One interesting point is that investment earnings by children in excess of $1800 per year are taxed at the parents' rate. You can see that someone already thought about how to take advantage of lower rates by moving funds to children accounts.

    The second goal that can be accomplished by gifts to his children is the reduction of currently taxable income for Pedro and spouse. As more and more funds are moved, the current income will reduce and therefore the currently payable tax will decrease.

    In addition to annual gifting, there is a lifetime exemption of 1M per person. Making this type of transfer will require the payment of gift taxes, but will accomplish the objective of reducing the taxable estate for the parents.

    In 2009, the tax rates for gifting amounts beyond the $13,000 annual exclusion are identical to the estate ...

    Solution Summary

    The 1873 word cited response provides a thorough discussion of each of the problems with notes about recent law changes.