CFA CFA Level 3 [Schweser] Exam 1 Morning Q7 Aii

# [Schweser] Exam 1 Morning Q7 Aii

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• vincentt
Participant
• CFA Level 3
0

Summary of the vignette:
Rine Ruby has core capital of Â£1,000,000 and excess capital to be Â£4,000,000. He would like to provide each of his children a relatively equal share of his accumulated wealth.

Rine Ruby Tax Data
Inheritance tax rate = 60%
Gift Tax rate = 30%
Marginal tax rate = 45%

Two children, Johanna, 25 and Albert, 27.

Ruby is considering a gifting program to his children. There is an annual tax-free exclusion of Â£15,000 on gifts to individuals. The tax code requires that gift taxes be paid by the recipient unless the gift is placed in an irrevocable trust. Gifts to irrevocable rusts allow the grantor to pay the gift tax. The trust would be subject to a 25% income tax rate. The expected real return on investments over the next 25 years is 5.5%.

Q:
Compute the relative value over 25 years of a bequest versus a gift made this year directly to Ruby’s children. Assume the transaction will be done in a tax-efficient manner. Show your work.

Basically it’s to do a ratio to see how much better is gifting now vs bequest 25 years later.

The solution in the book:
I got the bequest formula right so we shall leave that out however the gifting now bit (numerator) in the answer is a little simplified.

Gift now = [ 1 + Rg ( 1 – Tig) ] ^ n

I understand that the question mentioned tax-efficient manner which is to use up the 15k tax free, however Ruby has Â£5million and shouldn’t gifting now means to give the full 5m in total to both his children and only the 30k (15k * 2) portion will be excluded from the Tig tax (gift tax rate)?

So perhaps the formula should be

[ (1 – 0.30) + 0.30 * (30,000 / 5,000,000) ] * [ 1 + 0.055 * (1 – 0.25) ] ^ 25

First square bracket -> [ (1 – 0.30) + 0.30 * (30,000 / 5,000,000) ]
is just to deduct the full gifting tax and adding back the tax free part.

Second square bracket is just like the normal the normal return deducting the marginal tax rate of the children compounded by 25 years.

Now my questions are:

1. Why did they not deduct the gifting tax? Since it’s paid by the recipient (a requirement by the law), shouldn’t it be deducted from the gifting amount? How do we know if the recipient has the funds to pay the tax even?

2. Assuming that to give in a tax efficient manner which is to give up to the amount of 15k each, how would that be considered a fair comparison when you are only talking about giving 15k vs 5m for bequest?

@RaviVooda
â€Œ @Alta12â€Œ @MM12â€Œ

• Zee Tan
Keymaster
• CFA Charterholder
2

I haven’t seen the question but I’ll give it a go:

1. I’m assuming the absence of gift taxes is because the gift was transacted through an irrevocable trust, meaning that Ruby will be paying the taxes. Grantor pays tax in addition to the grant, so gift tax isn’t deducted. Gift tax rate is a red herring.

2. If the irrevocable trust route is used, the Â£15k allowance is not applied as it only applies to individuals, not if it’s placed in a trust.

3. Therefore the tax rate used is 25% (income tax on the trust) rather than 45% marginal tax rate (on children I’m assuming).

• vincentt
Participant
• CFA Level 3
2

@zee thanks for the response.

1. But to compare fairly even if Ruby were to pay the gift tax, shouldn’t the taxes get deducted from the Â£5m just like the bequest?
As we are comparing giving the amount to his children now via a trust and suffers a gift tax of 25% (and a annual tax deduction of 25% on the portfolio’s return based on the kid’s marginal tax rate)
vs
Annual tax deduction of 45% on the portfolio’s return based on Ruby’s marginal tax rate and a inheritance tax at the end.

The solution’s formula:
Relative value of tax free gift = FV gift / FV bequest
= [1 + Rg (1 – Tig)] ^ n / { [1 + Re ( 1 – Tie)] ^ n } * (1 – Te)

Te = inheritance tax
Tie = grantor’s marginal tax rate
Tig = recipient’s marginal tax rate

In the denominator the inheritance tax is deducted but in the numerator gift tax were not deducted. I understand that it states that “The tax code requires that gift taxes be paid by the recipient unless the gift is placed in an irrevocable trust.”, but if we were to use the trust for a tax efficient transaction, grantor would have to pay the tax and shouldn’t that get deducted from the Â£5m?

• vincentt
Participant
• CFA Level 3
2

@zee so if the grantor pays the tax (unless specifies otherwise) and if he’s still alive (not bequest) the syllabus assumes he should come up with the additional amount for the tax, but if it’s for bequest tax will be deducted from the amount (Â£5m in this case) ?

Guess this is the area that it’s a little confusing, perhaps it’s simplified for exam and not for real world.

• 2

@vincentt @zee the question is about relative value of gifting now vs bequest i.e. what the children will get. The gifting tax to be paid by the settlor will not be included in the numerator in this case.

• Zee Tan
Keymaster
• CFA Charterholder
1

If the grantor pays tax, it’s not included in the calculation, as the grantor pays in addition to the Â£5m. So if I gave you Â£5m at 25% gift tax, I would actually have to bring Â£6.25m to the table, and you’ll still receive Â£5m.

I know it’s not a ‘fair’ comparison in that sense but the point is to compare “what amount gets to my children”. It’s a bit of a weird area that I got confused with as well.