Revocable/ Irrevocable Trust tax minimization (cfai 2011 essay q1)

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tribeca_regent

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Client has two trusts (revocable and irrevocable) and is considering which portfolio to sell shares from with tax minimization in mind. All income/realized CG/ and estate tax is flat at 20%.
- Revocable : cost basis increases to MV at time of death and all asset subject to estate tax.
- Irrevocable : cost basis does not change and asset not subject to estate tax.

Both trusts will have identical CG taxes, but different estate taxes.
Why does the solution go with revocable trust? Since the irrevocable trust is not subject to estate taxes, would’t this minimize tax?
 
Irrevocable would pay more CG tax due to lower cost basis.
Not sure if both have the same tax.
Imagine original cost basis = $100, at death MV = $200, heirs sold at $300.
Revocable: Pay 20% * ($200 - $100) at death, pay 20% * ($300 - $200) when selling.
Irrevocable: Pay 20% ($300 - $100) when selling.
Don’t know why revocable is preferable.
 
Here’s what the solution says :
Current taxes on realized capital gains will be the same for either trust.
Assets in the irrevocable trust are not subject to estate tax.
Asset sin revocable trust are subject to estate taxes upon Becker’s death,at which time the cost basis will be increased to market value.
Thus, total taxes are minimized by selling from the revocable trust.
If irrevocable trust estate tax =0, does this mean the revocable trust gives a tax refund with the cost basis revalution? (highly highly doubtful)
 
Its is saying that you have a future tax liability in the revocable trust that is uncertain, your death. So the more assets you can move from the revocable trust it will lower your future tax liability which is (Market value of stock minus cost basis) * number of shares * tax rate. If you sell shares now, this will lower the number of shares and therefore your future tax liability.
 
Its is saying that you have a future tax liability in the revocable trust that is uncertain, your death. So the more assets you can move from the revocable trust it will lower your future tax liability which is (Market value of stock minus cost basis) * number of shares * tax rate. If you sell shares now, this will lower the number of shares and therefore your future tax liability.
 
This question bugged me initially, too - see if you can get with my logic:
  • Total taxes for the revocable trust will be 20% of the $900,000 gain ($180,000). The remainder of the position stays in the revocable trust and is subject to estate taxes, but because of the step up in basis at Becker’s death, cost=market and no estate taxes are due.
  • Total taxes for the irrevocable trust are double because it receives no favorable step up in basis when Becker dies. So, taxes are paid at 20% on the $900,000 gain we’re concerned with in Objective 1 ($180,000), and then again at 20% when the remaining $1 million position ($900,000 gain) is liquidated by his benfeciaries. Thus, TOTAL taxes are $360,000 in this instance.
Where I got hung up (and I’m guessing this is what tripped you up, too) is in focusing on minimizing CURRENT taxes. The focus on minimizing TOTAL taxes is what changes things.
Hope this helped.
 
^ Don’t follow. How is the $900K gain taxed twice in irrevocable trust?
If via capital gains, you have to sell first, to be taxed at all. And you can’t sell the same position twice.
 
first on the current capital gains at the time of transfer to the trust. (this piece is the same whether it is a revocable or an irrevocable trust)
and later on when there is estate tax applied.(and this is only for the irrevocable trust).
 
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