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MS, MTx, CFA, CFP®, CPA, PFS, CIPM
“… in this world nothing can be said to be certain, except death and taxes.” – Benjamin Franklin
Much has changed in the world of taxes because of the Tax Cuts and Jobs Act of 2017 (TCJA), but paying taxes remains (and, of course, we will all die eventually). I have written much over the last year regarding changes to taxpayers’ income tax liabilities, but none related to estates. The main reason? Not much changed, but there is plenty of planning still to do.
Estate Considerations Under TCJA
The original goal of President Trump was to eliminate the estate tax altogether. Like many other pieces of his grand tax plan, that didn’t happen. Instead, the lifetime exemption was doubled to $11.18 million per decedent, $22.36 million for a married couple. Tax rates stayed the same with a maximum rate of 40% and basis rules were unaltered. Therefore, the actual estate tax should impact only a very small minority of wealthy individuals and families.
Estate taxes are not the only planning concern when preparing estate documents. Consider income taxes for heirs, passing assets to the right people or trusts, planning for special needs heirs, and your own incapacity.
Since the estate exclusion amount has become so large over the last 20 years conventional estate planning has changed drastically. In 1998 the exclusion was a mere $625,000, whereas today it is $11,180,000! Before, decedents wanted to minimize their gross estate to avoid paying estate tax at 55% so the use of bypass trusts, marital trusts, pre-death giving, and more sophisticated planning was necessary. Now, decedents really have no concern about the size of their estate since they won’t owe the estate tax anymore.
So, how do we minimize income taxes using the new estate tax system? Internal Revenue Code (IRC) section 1014(a) allows for beneficiaries to adjust their basis in most[i] inherited property to the fair market value of the property on the date of the decedent’s death. This means the beneficiary can sell the property without recognizing any of the appreciation as capital gains!
Example: Jim dies and leaves his stock portfolio to his daughter. Jim’s basis in the stock portfolio was $100,000 but the fair market value had increased to $250,000 before his death. If Jim gifted the stock portfolio to his daughter, she would have to recognize the $150,000 of gain upon selling the stock. Since Jim left it to her in his estate, she will have a basis of $250,000, which equals the fair market value on the date of his death. This is a tax savings of $22,500 at the 15% long-term capital gains rate.
The general advice is for decedents to maximize the value of their estate (to the extent of the exclusion amount) with appreciated assets so their beneficiaries will gain a larger step up in basis on those assets.
Another way to take advantage of the step up in basis is “upstream gifting” or what I refer to as “gift-bequest back” transfers. The idea of the strategy is for younger generations (hereafter “kids”) gift appreciated property to the older generations (hereafter “parents”).[ii] The parents then bequeath the asset back to the kid at their death, thus providing a step up in basis.
There are several problems/cautions to this strategy:
Overfunded Bypass Trusts
The most common issue with older wills is the funding of bypass trusts. Prior to 2010, the only way to ensure that both spouses fully utilized their estate exclusion was to create and fund a bypass trust, often through the decedent’s will. Property to the extent of the exclusion amount would fund the bypass trust and the surviving spouse would get any remaining assets, utilizing the marital deduction to avoid estate tax.
In 2010 the estate law was temporarily revised, and then made permanent with the American Taxpayer Relief Act of 2012, to permit married spouses the use of any unused estate exclusion via “portability.” This vastly simplified the estate document drafting process since a bypass trust is generally not necessary anymore. At the first spouse’s death, all assets are left to the surviving spouse who elects to take the decedent’s exclusion later upon their own death. The surviving spouse must submit an estate tax return, even though no tax is due, to take advantage of portability.
Example: Bob and Janet are married with an evenly split estate value of $15 million. If Bob were to pass away and leave all his assets to Janet, he would not utilize any of his estate exclusion amount. The transfer would be estate tax free under the marital deduction. Janet could then elect to take Bob’s unused exclusion in addition to her own. Later, if Janet dies with an estate value of $18 million, she can offset the entire amount with both exclusion amounts (Bob’s unused amount and her own). Before 2010, Bob would have needed to fund a bypass trust for the same result.
The reason overfunded bypass trusts are a problem goes back to the income tax issue for beneficiaries. If one spouse dies leaving assets in a bypass trust, those assets only get a step up in basis at that first death. They will not step up again at the surviving spouse’s later passing. This leaves tax money on the table!
Example: Bryan and Katie are married with a joint estate valued at $1 million and basis (for gain purposes) of $700,000.
Overfunded bypass trusts can also cause non-tax problems related to access of funds for a surviving spouse. Many times, the expectation at drafting a will is that a portion of assets will funnel to the bypass trust and a portion to the spouse, a marital trust, or a QTIP trust. As the estate exemption has increased exponentially, many people now find that EVERYTHING goes to the bypass trust, leaving nothing to go outright to the spouse. It is important to consider how the changes in these limits affects your situation!
Even if there is no way you will owe estate taxes, planning around the estate transfer is important. Not only from a tax perspective (income and transfer), but also looking at time, legal fees, simplicity, guardianship, special needs, efficiency, and effectiveness. When looking at the tax angle, the old advice of minimizing your estate may actually cost your family more as the laws have changed. Keep in mind that your advisors and planning team at Kays Financial Advisory Corporation are here to help this or any other financial concerns you may have. Reach out to your advisor for more information.
[i] Certain property such as annuities, retirement accounts, pensions, net unrealized appreciation, and the new QOF deferred gains do not receive a basis adjustment. Note, this list is not exhaustive.
[ii] The use of “kids” and “parents” is to simplify the explanation. No familial or other blood relationship ties are necessary for this to work. It could also skip generations and be from “grandkids” to “grandparents” or “great grandparents”.
[iii] IRC Section 1014(e)
Bryan Strike, MS, MTx, CFP®, CFA, CPA, PFS, CIPM is a Senior Financial Advisor at Kays Financial Advisory Corporation. He can be reached at (770) 951-9001 or at email@example.com.
This report and Mr. Strikes’ comments are provided as a general market overview and should not be considered investment or tax advice or predictive of any future market performance.
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