How to Avoid An Unnecessary Income Tax Time Bomb in Your Estate Planning Documents

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Geoff Hoatson

Attorney / Principal

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.

In this issue you will learn what income tax basis is, how older estate plans have been deliberately designed to include an income tax time bomb, and the options you have to update your plan so that your heirs will receive the maximum basis.

The Basics of Income Tax Basis

In its simplest form, income tax basis is the cost to buy an asset, which includes the purchase price plus costs and transfer fees. 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. In other words, if the sales price is more than the basis, then the taxpayer must report a capital gain, but if the sales price is less than the basis, then the taxpayer must report a capital loss.

Basis plays an important role in estate planning in two ways:

Planning Tip:  You may unknowingly create an income tax bill for your children by gifting property during your lifetime instead of allowing your children to inherit the property after your death. A common example is when a parent deeds their residence to his or her child to avoid probate. If the child did not pay their parent anything for the residence, then the parent has made a gift of the residence to the child. If the parent’s basis in the property is $100,000, then the child’s basis is $100,000. If the parent lives in the property for 15 more years and then dies when the value is $500,000, the child’s basis is still $100,000. If the child decides to sell the property shortly after death, the child will owe capital gains tax on $400,000 ($500,000 sales price – $100,000 carry-over basis = $400,000 gain). If instead the parent had used a revocable trust or a payable on death deed to avoid probate so that the residence passed to the child after death, then the child would not owe any capital gains tax ($500,000 sales price – $500,000 stepped up basis = $0 gain).

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:

How to Build Basis Planning Into Your Estate Plan

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

Planning Tip:  For many married couples whose estates are not taxable, AB Trust Planning will cause more harm than good. For example, if a couple has been married for 50 years, they want to leave their estate to their children, and they are not particularly worried about the surviving spouse remarrying, an AB Trust plan will have two detrimental effects: (1) the deceased spouse’s assets will be unnecessarily tied up inside of a discretionary trust, and (2) the assets remaining in the trust when the surviving spouse dies will not receive a second stepped-up basis. On the other hand, a couple in a second or later marriage may prefer the benefits of a discretionary trust – providing for the surviving spouse but insuring that what is left goes to the deceased spouse’s heirs – but still want the deceased spouse’s heirs to receive a stepped-up basis.  Alternatively, either couple could live in a state that collects a state estate tax which makes AB Trust Planning a necessity. This is why basis planning has become so important and must be included in all estate planning discussions.

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 our office (407-574-8125) if you have any questions about basis planning and to schedule a consultation to have your Estate Planning documents reviewed.

This newsletter is for informational purposes only and is not intended to be construed as written advice about a Federal tax matter. Readers should consult with their own professional advisors to evaluate or pursue tax, accounting, financial, or legal planning strategies.

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