Estate Tax Planning for Modest Estates Now Focuses on Income Tax Savings
As a result, many modest estates no longer need to be concerned with federal transfer taxes. Rather, planning for such estates can now be devoted almost exclusively to income tax savings. While saving both types of taxes has always been a goal of estate planning, it was more difficult to accomplish when the estate and gift tax exemption level was much lower. High net worth individuals should also carefully examine ways to minimize state estate or inheritance taxes.
In 2010, the estate tax law was changed to allow a deceased spouse’s unused exclusion to be transferred to the surviving spouse. Now in 2015, a married couple will be able to transfer $10.86 million without incurring federal estate taxes. This is so, even if all or most assets are held by only one spouse. The exemption portability feature makes it easy for a married couple to achieve the combined exemption without resorting to complex strategies as were needed in the past. Many individuals or married couples with significant assets no longer have to be concerned about federal estate tax in light of today’s substantial exemption. As a result, such impacted high net worth individuals should reconsider the following strategies.
Making annual exclusion or other lifetime transfers
Each year, an individual can transfer an indexed amount ($14,000 for 2015) to an unlimited number of donees free of gift tax. Historically, one of the benefits of making use of the annual exclusion to make transfers to children, grandchildren and others was to save estate tax. This was because both the transferred amounts and any post-transfer appreciation would be removed from the donor’s estate. However, making an annual exclusion transfer of appreciated property carried a potential income tax cost. With such a transfer, the donee would get the donor’s carryover basis and could face a potential income tax liability on a future sale of the asset. Cash gifts, of course, do not pose such a problem.
The question now is: Should an individual continue to make annual exclusion transfers if there is no concern that his or her estate will be subject to federal estate tax, even if the potential gift grows in value? The answer is that the decision to make a gift should be based on other factors. For example, gifts may be warranted if the donee needs a down payment to purchase a home or funds to start a business. But gifting of appreciated property should be avoided because of the lurking capital gain that could be realized on a sale of the property by the donee. Based on current law, if the appreciated assets are held until death, the heir will get a step-up in basis that will eliminate the income tax on any pre-death appreciation in the value of the property.
In most cases, property that is suitable for gifting is a capital asset in both the donor’s and donee’s hands. If sold, the asset is subject to capital gains tax. So a basic review of how capital gains are taxed is in order. For 2015, an individual is subject to tax at a top marginal rate of 39.6% on short-term capital gains and ordinary income. Long-term capital gains are taxed at a rate of either 20% if they would be taxed at a rate of 39.6% if they were taxed as ordinary income, or 15% if they would be taxed at above 15% but below 39.6% if they were taxed as ordinary income, or 0% if they would be taxed at a rate of 10% or 15% if they were taxed as ordinary income. Plus a capital gain subject to the net investment income (NII) tax would be subject to an additional 3.8% tax.
Therefore, a gift of an appreciated asset that is later sold by the donee could be subject to a tax of almost 24% if the donee is in the top income tax bracket and the gain is fully subject to the NII tax. In most cases, it may be better to retain the asset until death to receive a step up in basis and wipe out the potential gain. However, if an appreciated asset is ripe for sale from an investment standpoint and the donee would be taxed on any capital gain at a 0% rate, then a gift of the appreciated assets should be considered.
An individual should carefully decide whether to make gifts and, if so, which assets to give. In addition to considering the federal tax consequences mentioned above, a taxpayer should also take into account the impact of any state capital gains tax and any state estate or inheritance tax.
Equalizing estates
In the past, spouses often undertook complicated strategies to equalize their estates so that each could take advantage of the estate tax exemption. The need to do that has been eliminated by the portability feature, which first became effective for estates of decedents dying after 2010. Specifically, the estate of a decedent dying after 2010 who is survived by a spouse may make a portability election. It allows the surviving spouse to apply the decedent’s unused exclusion amount to the surviving spouse’s own transfers during life and at death. The amount received by the surviving spouse is called the deceased spousal unused exclusion, or DSUE, amount. In general, the election must be made within nine months of the decedent’s death on the federal estate tax return, even if the estate is below the exclusion amount so that a federal estate tax return normally would not be required.
Prior to 2010, the estate tax law did not allow for any unused portion of a decedent’s applicable exclusion amount to be used by the estate of the decedent’s surviving spouse. Because of this, married couples typically implemented a two-trust estate plan to take advantage of each spouse’s applicable exclusion amount: (1) a credit-shelter trust making use of the applicable exclusion amount, and (2) a marital trust qualifying for the marital deduction. The problem is that this approach ignores step up in basis. Under the traditional approach, there’s a step up in basis at the death of the first spouse to die, but there’s no step up in basis at the surviving spouse’s death. This is because the credit shelter trust was designed to keep the assets outside the estate of the surviving spouse so that any growth in value would pass estate tax free to the children or other heirs. Married couples should now consider whether their combined estate value is such that they’ll never have more than the applicable federal estate tax exemption, currently $10.86 million. If this is the case, the assets of the first spouse to die should be left to the surviving spouse either outright or in a marital trust. This way, the assets will be included in the surviving spouse’s estate at death, and there will be a second step up in basis at the death of the surviving spouse. This strategy takes advantage of a double step up in basis and should be considered by married couples.
However, if there are asset protection or spendthrift concerns of the surviving spouse, the credit-shelter trust can protect assets from being squandered. It can also protect against creditors. A credit shelter trust lets the first spouse to die control disposition of the assets after his or her death. Conversely, if everything is left outright to the surviving spouse with the hope of making use of the deceased spouse’s exclusion, the surviving spouse will be able to control the ultimate disposition of the assets.
With modest estates not having to be concerned about federal estate tax, some strategies to avoid having property be included in the estate may no longer be worth pursuing. It may be better to have the property included so that a step-up in basis (or even a double step-up) can be achieved. If you have any questions or would like to further discuss the income tax aspects of estate and gift planning, please contact a member of WS+B’s Estate and Trust Services Group at [email protected].
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Mary Ellen Meara, CPA 609-520-1188 [email protected]
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