The New “Death Tax”

The lifetime exemption from Federal estate tax (sometimes called the death tax) was permanently increased to $5.00 million plus inflation adjustments (measured from 2010) as part of the American Taxpayer Relief Act of 2012.  It had been scheduled to drop from $5.12 million to $1.00 million in 2013.  For 2016, the exemption stands at $5.45 million.  Because each spouse has this limit, a married couple effectively has a $10.90 million combined exemption.  The government also permanently enacted “portability” enabling the surviving spouse to elect to “port” or add to her or his own lifetime exemption any unused exemption of the deceased spouse.  The large exemption amounts in effect make the estate tax applicable only to a tiny percentage of taxpayers, estimated to be 0.6% of all taxpayers.  Given that almost no one pays the estate tax, what then is the new death tax?  Answer:  it is the income tax.  The income tax is the tax that most people should plan for in their estate planning documents.  Unique income tax benefits and detriments associated with trusts and estates require careful planning. 

When a person dies, the income tax basis of the assets that are included in the gross estate of the decedent changes to be equal to the fair market value (FMV) as of the date of death (or the “alternate valuation date” if that election is made for a tax-paying estate).  An exception applies to assets that are considered “income in respect of a decedent” (IRD).  IRD assets are typically tax-deferred retirement accounts such as 401(k)s, traditional IRAs, and also accrued income items such as accrued interest and dividend income, and unreported income from installment sale contracts.  These IRD assets do not receive a new income tax basis at death.  In addition, if the new basis conformity reporting isn’t complied with when required (see my blog post here), the tax basis of unreported inherited assets becomes zero.  In most instances the FMV will exceed the tax basis of the assets.  Therefore, changing the tax basis to FMV eliminates the inherent capital gains tax.  The new reality of the high estate tax exemption amount should change the emphasis in estate planning from reducing the estate tax (that most likely won’t be owed) to reducing the income tax (that will be owed). 

Putting the emphasis on income tax reduction when structuring estate plans requires looking at both lives for a married couple.  If the surviving spouse continues to live for a number of years, the FMV of the assets owned by the decedent spouse should continue to increase.  If such assets could be included in the gross estate upon the death of the surviving spouse, the assets in effect receive a “second step-up” in income tax basis.  Below are some planning suggestions.  A variety of factors must be considered before adopting any of these suggestions. 

1.      Consider changing your existing estate plan from using the traditional A-B trust structure to simply leaving all assets of the first spouse to die to the surviving spouse, whether directly or in a qualifying trust, and electing portability.  The traditional structure allocates the first spouse’s assets to the B trust (sometimes called the credit shelter, bypass, or family trust) in an amount equal to the unused estate exemption amount.  The balance of the assets (if any) are left to the A trust for the surviving spouse.  The traditional A-B structure is an attempt to use the deceased spouse’s estate exemption that would be lost if not used.  But now, with the availability of the portability election, any unused exemption will be preserved.  The tax problem with the B trust is that the income tax basis of the trust assets will be frozen at the FMV at the time of the first death.  The B trust is designed not to be included in the gross estate of the surviving spouse; therefore, there is no second step-up upon the death of the second spouse.  Leaving the first spouse’s assets to the surviving spouse, whether directly or in a qualifying trust, enables those assets to receive a second step-up in basis.  Before changing your A-B trust structure, other reasons for the structure, such as asset protection or multi-generational trust purposes must be considered.

2.      If the older/sicker spouse owns an irrevocable grantor trust from prior gifting or estate planning strategies, there will likely be a provision in the trust document that permits the spouse-grantor to substitute or replace assets in the grantor trust with assets of like FMV.  Substituting high basis assets for low basis assets in the trust will bring the low basis trust assets into the spouse’s gross estate for a basis step-up.

3.      If the A-B trusts already exist, or if there are other gifting or estate irrevocable trusts that are nongrantor trusts, then the income tax burden of these trusts can be quite high.  For example, in 2016, the top 39.6% ordinary and 20.0% capital gain tax rates begin at only $12,400 of trust taxable income, whereas for a married couple, such rates don’t begin until $466,950 ($415,050 for single taxpayers).  Distributions of trust taxable income to beneficiaries can often result in less overall tax.  Distributions just for income tax reasons should, however, be consistent with the trustor’s purposes for the trust.

4.      When drafting a trust document, the distribution language should give discretion to the trustee to make distributions from income and principal, and should give the trustee authority to define trust accounting income, such as including capital gains in the definition.

5.      Give the older/sicker spouse ownership of appreciated, low-basis property so that it might receive a basis step-up.  However, a special rule prevents a basis step-up if the deceased spouse received the property within 12 months of death from the person inheriting the property.

6.      Have the older/sicker spouse gift high-basis property having an unrealized loss so that the high basis might be preserved instead of being “stepped down” to FMV upon death.  While there are limitations on how much loss can be triggered on the sale of gifted high-basis property, the preserved basis will be available to reduce the capital gain if the property’s value recovers.

7.      Avoid fractionalizing ownership interests to obtain large valuation discounts.  If you don’t have estate tax, you want high valuations to obtain higher tax basis for the property to be inherited by your heirs.

8.      Elect portability where it makes sense.  Electing portability to preserve the unused lifetime estate tax exemption requires the filing of a timely estate tax return for the deceased spouse.  Preparing an estate tax return is expensive, costing thousands of dollars, so it must fit the family’s circumstances to be worthwhile.