As the federal estate tax exemption has ballooned from $1.5 million ten years ago to $5.43 million today, the need for estate tax planning has drastically decreased.  Instead, higher income tax rates that were ushered in under the American Taxpayer Relief Act of 2012 (ATRA) have shifted the focus of estate planning to a new frontier:  income tax basis planning.

The Basics of Income Tax Basis

In its simplest form, income tax basis is the cost to buy an asset.  Basis must be tracked because when an asset is sold, income tax liability in the form of capital gains is calculated by subtracting the basis from the sales price.  Basis plays an important role in estate planning in two ways:

  • Carry-Over Basis: When property is gifted during life, the recipient of the gift receives the donor’s basis in the property, referred to as “carry-over basis.”  For example, if you purchase 100 shares of Facebook stock for $60 per share for a total of $6,000 but then gift the stock to your son when the price is $100 per share, his basis in the stock is $6,000 (even though the fair market value is $10,000).
  • Stepped-Up Basis: When property is transferred after death, in general the inheritor’s basis in the property is the fair market value on the date of death, referred to as “stepped-up basis.”  For example, if you purchase 100 shares of Facebook stock for $60 per share for a total of $6,000 but then die and leave the stock to your son and the price is $100 per share on your date of death, then your son’s basis in the stock is stepped-up to $10,000.

AB Trust Planning:  An Income Tax Basis Nightmare for Many Couples

Including assets in a deceased person’s estate is the key to giving heirs a stepped-up basis.  Yet traditional planning for married couples using an AB Trust Plan deliberately excludes property from the surviving spouse’s estate.  An AB Trust Plan, also known as a Marital or QTIP Trust/Family or Bypass Trust Plan, works as follows:

  • When the first spouse dies, their estate plan provides that an amount equal to the federal estate tax exemption will go into the Family Trust and any excess will go into the Marital Trust. For example, if Joe dies in 2015 with an estate valued at $6 million, then $5.43 million will go into the Family Trust and $570,000 will go into the Marital Trust.  The assets in both trusts receive a stepped-up basis as of Joe’s date of death.
  • Mary, Joe’s wife, will have access to the income and principal of the Family Trust to provide for her health and maintenance, receive all of the income from the Marital Trust, and also have access to the Marital Trust principal to provide for her health and maintenance.
  • When Mary later dies in 2025, any property remaining in the Marital Trust will be included in her estate and receive a stepped-up basis as of her date of death. However, any of Joe’s property remaining in the Family Trust keeps the basis as of Joe’s date of death in 2015.  Because there’s no stepped-up basis at Mary’s death, the Family Trust potentially contains an income tax time bomb.

How to Build Basis Planning Into Your Estate Plan

There are several options to choose from if your goal is to maximize basis for your heirs:

  • Undoing an AB Trust Plan and instead leaving everything outright to the surviving spouse will result in a stepped-up basis for the entire estate.
  • Giving the surviving spouse or other beneficiary of a lifetime trust a general power of appointment will cause estate inclusion of the remaining trust assets at death, thereby resulting in a stepped-up basis.
  • Granting a trust protector or advisor the ability to add a general power of appointment to cause estate inclusion at the beneficiary’s death takes a wait-and-see approach to basis planning.
  • Decanting an existing irrevocable trust that does not include basis planning into a new trust that does is an option in some states.
  • Swapping low basis assets held in a defective grantor trust for cash or other high-basis assets will bring the low basis assets back into the grantor’s estate.

Your circumstances will impact which option is the best fit. The great news is there’s almost always something that can be done to achieve your estate planning and asset protection goals with good basis planning.

Do You Need a Basis Planning Review?

Instead of falling back on “one size fits all” AB Trust plans, today estate planners must look carefully at each client’s unique family situation, financial position, and potential estate tax liability to determine the appropriate mix of techniques to minimize both estate taxes and income taxes.  If your estate plan is more than a few years old, chances are it contains an income tax time bomb.  Please call us if you have any questions about basis planning and to arrange for a basis planning review.