Following graduation, you meet Mr. Big at a country club. Mr. Big is a venture capitalist who has a sizable stock portfolio concentrated in a single firm, Blue Hat. After several weeks of golfing together, Mr. Big confides in you regarding his financial situation. He owns $ 30 million of Blue Hat stock ($ 100 per share, 300,000 shares) with a basis of $ 20 per share. Mr. Big has one child, Big Jr. Mr. Big, who is 75 years old and in poor health, tells you that he just put in an order to sell half his Blue Hat stock and that he will invest the after- tax proceeds in T- bills because he thinks the market is overvalued. Assume the gains from the sale are taxed at a 15% long- term capital gains rate.
One year later, Mr. Big passes away, leaving his entire estate to Big Jr. Because of changes in short- term interest rates, the T-bill portfolio he had purchased with the stock sold has produced no after- tax return. At the date of death, Blue Hat is trading at $ 150 per share. Mr. Big’s estate pays for any estate taxes by first liquidating a portion of the T- bill portfolio and then, if necessary, a portion of the Blue Hat stock. Consider these two reminders about estate taxation: First, estates pay an estate tax on the fair market value of the net estate (assets less liabilities). Assume the estate tax rate is 45% for the year in question. Second, it often takes some time for an estate to pay off the debts of the decedent and distribute the net assets to the heirs. In the meantime the assets of the estate may generate income. To prevent this income from going untaxed, estates are required to pay income tax on their earnings. Assume that the income tax rate faced by the estate is 40%. Sometimes estates have negative taxable income. If an estate reports net losses on its final tax return, assume those losses pass through to the heirs, otherwise they would be lost.
a. How much will Big Jr. inherit after all estate taxes have been paid?
b. Later in the year after Mr. Big’s death, Big Jr. recognizes $ 5 million in long- term capital gains from the sale of other stock from his personal portfolio. How much tax will Big Jr. pay on the sale, net of any capital losses he may have inherited from Mr. Big?
c. With the same facts as part (a), and instead of selling his Blue Hat stock, Mr. Big sells short $ 15 million of Green Hat stock, which Mr. Big figures is somewhat correlated with Blue Hat stock. Assume Federal Reserve rules on short sales prevent Mr. Big from selling short more than 50% of the value of his long position. The proceeds from the short sale are invested in T- bills. The short sale is held open until Mr. Big’s death. Mr. Big’s estate liquidates enough T- bill and Blue Hat stock (T bills first) to close out the short sale of Green Hat and any estate taxes. Any remaining Blue Hat stock is distributed to Big Jr. At the date of death, Blue Hat stock has increased in price to $ 150 per share. Green Hat stock has also increased in value and the short position requires $ 22.5 million to close out. What will be the current market value of the Blue Hat stock that Big Jr. gets from the estate?
d. Later in the year after Mr. Big’s death and given the circumstances in part (c), Big Jr. recognizes $ 5 million in long- term capital gains from the sale of other stock from his personal portfolio. How much tax will Big Jr. pay on the sale, net of any capital losses he may have inherited from Mr. Big?