In celebration of my columns fourth year, I have a test of the most frequently misunderstood aspects of our tax system.
Question: Which statement is most correct: (a) the two main tax systems in the U.S. are the income and transfer (gifts and estates) taxes; (b) the income tax applies to the person or entity earning or receiving income; (c) the transfer tax burdens the person or estate making the transfer; (d) all the above.
Answer: (d). The U.S. has two distinct taxing regimes: An annual income tax system for taxpayers to report and pay taxes on their income and a transfer tax system involving transfers during life (gifts) and transfers at death (estates). Generally, the transfer tax does not affect the person receiving gifts or inheritance. Tax is paid by the person or estate making the transfer (donor) "for the privilege of making the transfer." When a transferee (donee) receives a gift, it is ordinarily received both gift and income-tax free.
Question: My parents gifted me $10,000 in cash. Which is true: (a) My parents must pay gift tax; (b) Neither of us pays gift or income tax; (c) I must pay income tax; (d) I must pay gift tax.
Answer: (b) Neither party pays gift or income tax on this transfer. Generally, annual gifts to an individual aggregating $10,000 or less in value are excluded from gift taxes. Husbands and wives are permitted to make annual gifts of $20,000 per year, per donee.
Question: My parents receive stock dividends of $10,000 per year. Which statement is correct: (a) They may avoid income taxes by gifting the dividends to me; (b) They may avoid gift taxes by gifting the stock in trust for 5 years, naming me as beneficiary; (c) They must pay income tax on the dividends, but will avoid gift taxes if they transfer the dividends to me.
Answer: (c). (a) is wrong because your parents cannot avoid income taxes by transferring to you the income they would have received. If they gifted their actual stock, then future dividends would be taxed to you. Note: gifts can be made by any person to any person, not just relatives. (b) is also incorrect. Gifts of a future interest, such as a gift in trust, do not qualify for the annual gift tax exclusion. Note: married U.S. taxpayers may make unlimited gifts between themselves, but gifts to a non-resident alien spouse are limited to a total of $100,000 per year.
Question: My parents give me stock worth $10,000. Their basis (the amount paid) for the stock was $1,000. Which is true: (a) My parents must pay gift tax; (b) I must pay gift tax; (c) If I sell the stock for $10,000, my gain will be $9,000 and I must pay income taxes; (d) If the stock is sold for $10,000, my gain will be zero and I will not owe tax; or (e) Neither of us pays gift or income tax.
Answer: (c) You receive a carryover basis of $1,000 (the donors basis becomes yours) in the stock. A later sale at $10,000 produces a taxable capital gain of $9,000 to you. You also add the donors holding period to your own. For instance, if your parents owned the stock for 12 months, then you owned it for seven months, your holding period would total 19 months, qualifying you for the lower capital gains rate (usually 20%, but 10% if you are in the 15% tax bracket).
Question: When father died in 1998, I inherited his entire estate (a $100,000 bank account). Which is true: (a) My fathers estate must pay estate tax; (b) I must pay estate tax; (c) Neither of us pays estate or income tax; (d) I must pay income tax on the $100,000.
Answer: (c). An estate, not its beneficiaries, is primarily liable for estate taxes. In this case, since your fathers estate is below $625,000 (the unified gift and estate tax credit equivalent for 1998), his estate will not owe federal taxes. California does not separately tax an estate.
Question: I received a $100,000 inheritance and placed it in a savings account. True or false: If I withdraw $50,000 and spend it, I must pay income tax on this amount.
Answer: False. You do not pay income tax on the original principal, even though you inherited it tax-free, but you will be subject to income tax on all the interest earned. Our tax system, unlike some other countries, does not tax accumulated wealth on an annual basis. For transfer tax purposes, however, your inheritance is treated like any other property and is subject to gift and estate tax rules.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**