Breaking Bad (season 1) (Photo credit: Wikipedia)
One of the greatest things about movies and TV is that we don’t have to understand every aspect ofthe plot in order to enjoy what we’re watching. Case in point, I’m not even sure Dumb and Dumber had a plot, but I still laugh like hell every time its on TBS. Or consider the closing scene of Trading Places. I’ve been working in the financial world for fifteen years now, yet I still have no idea how Billy Ray and Winthorpe got rich while bankrupting the Duke brothers by buying and selling frozen orange juice futures contracts. Nevertheless, it remains one of my favorite movies of all time. (Merry New Year!)
On Sunday night, ten million Americans tuned in to the finale of Breaking Bad. Long before Walter White turned a machine gun loose on a room full of Nazis, he paid a visit to Gretchen and Elliot Schwartz, his former co-founders of Gray Matter Technologies and a large source of the insecurities that eventually pushedhim to establish his own legacy as the greatest meth cook who ever lived.
Walter is determined to get his remaining cash to his son, but since Walter Jr. hates his dad and would never accept a dime from him, Walter has to find another avenue. Plus, there’s that little matter of Walt being responsible for the death of two DEA agents, meaning the government would surely confiscate any illegal drug money funneled to his family.
But as he always did over the course of five seasons, Walter White had a fix. He explains to Gretchen and Elliot that they will “make things right” and do his work for him. On Walter Jr.’s upcoming 18th birthday, Gretchen and Elliot will set up an irrevocable trust for his benefit using the last $9,720,000 million of Walter’s $81 million haul from cooking the blue. The cash is to be Walter Jr.’s to do with as he sees fit.
While this brief financial intrusion into an hour full of shootin’ and poisinin’ in no way deterred from the episode, if you don’t ply your trade in the tax world, you might have been left a little confused as to what exactly had just happened.
To clear up the confusion, I shot an email over to WithumSmith+Brown’s resident estate and trust expert, Hal Terr, to shed some light on what Walter had just done with his legacy from a financial perspective, and whether he had done Walter Jr. right.
Here’s what Terr, also a Breaking Bad fan, had to say:
“At first blush, there would be neither income tax norgift tax consequences to Walter Jr. upon receiving the $9.7 million in cash.Gifts are neversubject to income tax to the recipient under Section 102, and from agift tax perspective,it is generally the donor who bears the tax consequences. Elliot and Gretchen, upon establishing the trust for Walter Jr., would be required to pay any gift tax.
Of course, every taxpayer has a lifetime gift exemption, currently set at $5.25 million for 2013. Since Elliot and Gretchen are married, they each have an exemption, meaning they could make a gift of up to $10.5 million to Walter Jr. before any gift tax would be due, assuming they had not previously utilized their lifetime exemptions. So in theory, the entire gift could have been tax-free to all parties.
You have to consider, however, that Elliot and Gretchen were prominent philanthropists. In fact, they had recently promised to give $28 million to help victims of meth amphetamines as a way to publicly distance themselves from the crimes of their former co-founder. While charitable gifts do not reduce one's lifetime gift exemption,based on their wealth and giving nature (they did once offer to pay for Walt's cancer treatment)it's reasonable to conclude that Elliot andGretchen have also been doing a lot ofnon-charitable gifting, andhave already fully utilized their combined $10.5 million gift tax exemption. That would mean that the entire gift to Walter Jr. would be taxable, and Elliot and Gretchen would have to pay a 40% gift tax on the $9.7 of cash placed into trust for Walter Jr., or $3.9 million. That’s a pretty hefty price for doing Walter’s dirty work.
But don’t forget, as it has over and over and over again, Walter’s pride got the better of him. He instructs Elliot and Gretchen not to use a single dime of their own money, “If there are any taxes due,” he orders, “you are to take them out of my money, not yours.”
So what happens now? If the taxes are to be paid by the beneficiary, Elliot and Gretchen will have to give what’s called a “net gift.” In a net gift, the donor can reverse the rules that typically require him or her to bear the tax consequences and shift the burden to the donee.
A net gift works like so:
Assuming Elliot and Gretchen had in fact each burned through their $5,250,000 lifetime gift exemption, any additional gifts would result in a gift tax liability. Keep in mind, however, that in addition to the lifetime gift exemption, Elliot and Gretchen each have a $14,000 annual gift exclusion, or $28,000 total. So of the $9,720,000 gift they make to Walter Jr., $9,692,000 will represent a taxable gift, with $28,000 coming out of their annual gift exemption. This annual exemption is per donee, so it is not reduced by other gifts they may have made.
Under the gift tax rates, a gift of this size falls in the 40% gift tax bracket, so the gift tax bill on the $9,692,000 gift would ordinarily be $3,876,800. If the tax must be paid from Walter Jr.’s cash, however, then the true value of the gift is not $9,692,000, but rather $5,815,200 (gift less the tax). So the gift tax theoretically should only be 40% of the net value he is receiving, or $5,815,200 ($2,326,080) rather than $3,876800.
But if that were the case, then the value of the gift would increase once again, to $7,365,920 ($9,692,000 - $2,326,080) which would in turn cause an increase in the resulting gift tax liability. We’d have created a circular mess, going on and on and on.
To escape the circular calculation, the IRS permits the following formula to be used to arrive at the tax:
tentative tax/(1 + tax rate)
The tentative tax is the tax liability on the unreduced amount of the gift, or $3,876,000 in the above example. Then, we divide by one-plus-the-tax-rate, resulting in a net gift tax of $2,769,143 ($3,876,000/1.40). This makes the net value of the gift $6,922,857, which is the cash of $9,720,000 less the $28,000 combined annual gift exemption less $2,769,143 in gift tax. So Walter Jr. walks away with nearly $7 million, which while more than enough to buy another Mustang and pay back Louis for all those rides to school, is not what it could have been if Walter had just let Gretchen and Elliot reach under their couch cushions and pay the tax themselves. Seems only fair, given what they’d done to him on Charlie Rose.
But when it’s all said and done, Walter’s pride cost his son nearly $3.0 million, before considering any New Mexico gift taxes. And if we learned anything about Walter White during his five year run as Hesienberg, it’s that this type of miscalculation will have him spinning in his grave."
And that, ladies and gentlemen, is why I go to Hal Terr for all of my estate and trust needs.
Tread lightly,
Tony
