By: Randall A. Denha, J.D., LL.M.
The planning you did yesterday may not be the planning you do today. This is due to the increase in income tax, additional income taxes imposed as a result of the recently enacted American Taxpayer Relief Act of 2012 (“ATRA”), reduction in itemized deductions for high income wage earners and lessening of the transfer tax rates and increase in exemption. In plain English, under the old estate tax laws, it was usually better for a married couple to shelter the maximum amount from estate tax at the first death by use of a “bypass” or “credit shelter” trust. Now that the unused estate tax exemption can be transferred to the surviving spouse through a “portability election”, it may be better to include more in the surviving spouse’s estate to get a higher income tax basis in family assets when the spouse dies.
A byproduct of this “bypass” or “credit shelter” trust planning was the loss of a basis step up for income tax purposes when a surviving spouse died. Put another way, the general rule is that the basis of an asset is stepped up to its fair market value at the date of death, however, this is not the case for assets held in a bypass, credit shelter and irrevocable trust because such assets are not part of the surviving spouse’s estate. For example, if an asset cost $100.00 and at death that same asset is worth $1,000.00 then the step-up in basis rules say that the beneficiary now owns an asset with a basis of $1,000.00. This is a tax win for the beneficiary because the capital gain (or $900.00 appreciation) has been done away with and replaced with a fair market value at the date of death. The increased estate and gift tax exemptions mean that the 40% tax on gifts and estate transfers is a concern primarily reserved for the most affluent of U.S. citizens. In fact, just 3,800 estates are expected to owe any federal estate tax in 2013, according to estimates from the Tax Policy Center.
For example, if one spouse owns real estate worth $500,000 at that spouse’s date of death, and the real estate ends up in a bypass trust in order to keep it out of the surviving spouse’s estate, and at the second death the real estate is worth $2,000,000, then there will be a $1,500,000 capital gain that would be taxed when the real estate is sold. Assuming a federal income tax rate of 20%, the 3.8% Medicare surtax on investment earnings, and a Michigan income tax of 4.25%, the tax would be approximately $404,000 (this example does not account for any depreciation recapture, which would increase the tax liability).
A word of caution, though: With the federal exemption so high, the temptation to make sizable gifts can lead to higher capital gains taxes when the family later sells an asset that has been given to them. Years ago, with estate tax exemptions low and rates high, it was almost always better to make lifetime gifts than to pay estate tax, even if it meant higher capital gains tax when an asset was sold. That is no longer the case for families with assets below the federal estate tax threshold. If the federal estate tax does not apply, then the only estate tax may be at the state level (depending on the state.) State estate tax rates tend to be significantly lower than the current federal capital gains tax rate of 20%. Also, for sales of tangible objects such as art or fine furnishings, the federal capital gains tax rate is 28%.
Among other things, ATRA established the estate tax exemption amount at $5,000,000 per person, with this amount increasing annually based on inflation. For 2014, the exemption amount is $5,340,000 per person. Since 1997, there has been a significant increase in the estate tax exemption amount from $600,000 to its current $5,340,000 in 1997. As a result of the increased exemption from estate tax, there are clients who no longer have exposure to the federal estate tax even if all of the previously gifted assets or assets which funded a trust when the first spouse dies were now included in their estates. However, these clients – given the structure of their estate plan – cannot achieve a basis step up at death.
In fact, since the increase in exemption in recent years, there are some clients who want to “untie” the assets with regard to prior planning which was done, but this is not always possible. For example, although an irrevocable trust can be terminated in certain circumstances, the termination of the trust will require the consent of all beneficiaries and the fiduciary obligations of the trustee may make termination difficult and any termination could expose the assets to creditor attack. Similarly, a family limited partnership may be unwound, but the distribution of the property owned by the partnership may have adverse tax consequences and, like a trust, the creditor protection afforded by the limited partnership will be lost.
So what can be done to amend an estate plan to provide for an income tax advantage (i.e. basis step up?) There are several options that can be considered depending on your situation.
• For clients that have established family partnerships, the client could take the position that an implied agreement existed among the partners so that the partnership was, for estate tax purposes, a sham. Therefore the partnership assets are part of the decedent’s estate. The risk of this strategy is that creditors may be able to disregard the partnership as well.
• For clients who have established a qualified personal residence trust, the client could argue that an implied agreement exists whereby the clients would continue to use and enjoy the residence after the trust terminates (for example, by staying at the property without paying rent).
• For clients who established irrevocable trusts during their lifetimes, the trust agreement could be amended to give a third party, such as the trustee, the discretion to grant the client a “limited power of appointment.” The limited power of appointment provides the client with the right to shift the benefits of the trust among the beneficiaries, and results in the inclusion of the trust’s assets in the client’s taxable estate, even if not exercised. The risk with this strategy is that the third party must actually grant the client the limited power of appointment prior to the client’s death.
• A trust agreement may be amended to grant the beneficiary (such as a surviving spouse) a “general power of appointment.” A general power of appointment allows the beneficiary upon his or her death to direct the trust assets to any person or entity and therefore results in the inclusion of the trust assets in the beneficiary’s estate. This strategy presents the problem that the beneficiary may direct the trust assets outside the family and also presents creditor protection issues. The trust agreement could also be amended to give the third party the discretion to grant the general power of appointment to the beneficiary (although this presents the same timing issues as the limited power of appointment strategy outlined above).
Each client’s situation is unique, and caution should be exercised in employing any strategy to gain a basis step up. Generally speaking, implementing a basis step up strategy could upset a decedent’s estate plan or create an opportunity for a creditor to recover assets that were otherwise creditor protected. Nonetheless, the trading of an inheritance tax for the basis step up may be worth the potential risks.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.