When Estate Planning Becomes Basis Planning

Monday, December 22 at 10:35 AM
Category: Personal Finance

Old conventional wisdom: Minimize estate and/or inheritance taxes by making lifetime transfers and taking appropriate steps to reduce the taxable value of transfers. New conventional wisdom for many “smaller” estates: Avoid lifetime transfers, especially of appreciated assets, and maximize asset values at death.

Under the old tax regime, with a 40 percent federal estate tax and a 15 percent maximum capital gains tax for heirs, the tax-wise choice was pretty easy. Give assets away during life, even though the donor’s tax basis carries forward to the donee, because 15 percent of the taxable gain is going to be a much smaller tax bite than 40 percent of the gross value. Now, however, that calculus goes the other way. With a federal estate tax exemption of $5.34 million this year ($10.68 million for married couples), 99.8 percent of estates will no longer need to worry about paying any estate tax at all. In 2015, the exemption is now projected at $5.43 million. For estates below these thresholds, the tax benefit to zero in on is the step-up in basis* at death. Basis step-up is even more valuable now that the top tax rate on long-term capital gains is 20 percent, plus an additional 3.8 percent net investment income tax from the Affordable Care Act.

Example. Grandfather’s investment portfolio is worth $4 million, with a tax basis of $1 million. He plans to divide the portfolio among four grandchildren. If he makes a lifetime gift of the securities, and assuming that the basis is divided equally, each grandchild will have to plan for taxes on $750,000 worth of gains. If grandfather holds the assets until his death, the tax on the $3 million capital gain is forgiven at zero estate tax cost.

Exceptions
Not all assets received from a decedent get a basis step-up. Most importantly, income in respect of a decedent does not change basis. The most common examples are retirement plan assets and traditional IRAs. Accordingly, it may prove beneficial for an IRA to be converted to a Roth IRA before death. Similarly, the net unrealized appreciation in employer stock distributed from a qualified retirement plan does not get a basis step-up at the death of the participant.

Spousal transfers
There is a special rule for spousal transfers shortly before death, dating back to when the percentage and dollar limits on the marital deduction were eliminated. Apparently, Congress was worried about the possibility of transfers to dying spouses so as to obtain a basis step-up without having to pay an estate tax. Although the law is 33 years old, there have been no regulations, revenue rulings or revenue procedures explaining its application.

If an appreciated asset is given to a spouse, the spouse dies within a year, and the asset is reacquired by a surviving spouse, there is no basis step-up under this provision. The rarity of this sequence of events may account for the lack of IRS guidance.

Basis planning for married couples has been simplified somewhat by the advent of the portable federal estate tax exemption. If an entire estate passes to a surviving spouse outright, the unlimited marital deduction defers all federal estate tax. The survivor also inherits the unused federal estate tax exemption.

Recordkeeping
In order to secure the income tax benefits of basis step-ups, executors or personal representatives of estates will need to document very clearly the value of all assets at the date of the decedent’s death. Appraisals will be needed for nonmarketable assets. This should be done as soon as possible, rather than waiting until a later sale.

Note also that there is no statute of limitations for tax basis, so basis records must be kept indefinitely. If an inherited asset is sold 20 years after it is received, the donee will need to refer to those decades-old records to determine gain or loss.

Reprinted from Merrill and Anderson (November2014) © 2014 M.A. Co. All rights reserved

Links marked with * go to a third-party site not operated or endorsed by Arvest Bank, an FDIC-insured institution.

Tags: Financial Education, Retirement
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