Estate taxes will not concern as many families now that the federal estate tax exemption amount has increased to $5.34 million. The increase in the marginal estate tax brackets, coupled with the Medicare Surtax result in income tax planning becoming more important inside of many family’s estate plans.
I recently attended the Heckerling Estate Planning Conference, a one-week high level continuing education course designed for trust and estate attorneys, CPAs and trust officers. Top academics and lecturers impart wisdom on the 5,000 attendees from around the country on how to help family’s plan their estates to minimize taxes and achieve the family’s goals.
During one of the sessions, an interesting idea surfaced related to the elimination of capital gains by “reversing” the normal estate plan. Instead of leaving assets down the generational line, this strategy actually moves assets from a younger generation member to a parent or other older generation family member.
In order to understand the strategy, one must first understand the “step up” in tax cost basis concept. If I purchase a stock at $1/share and later sell that stock for $10/share during my lifetime, I recognize a $9 capital gain and pay taxes on that capital gain. If, however, I die with that stock in my estate and it is worth $10/share, generally speaking my beneficiaries receive a “step up” in tax cost basis equal to that asset’s date of death value.
So, in my example, if I die with stock worth $10/share and leave it in my will to my children, and if my children were to sell the stock at $10/share shortly after my death, then they would not recognize the capital gain that I would have recognized had I sold the stock the day before I died.
Normally individuals’ estate plans leave assets to their spouses, children and grandchildren – not to their parents who have a shorter life expectancy. But consider a strategy where an individual has an asset worth $1 million that has a tax cost basis of zero. If he were to sell the asset, then he would recognize a capital gain equal to $1 million and pay 23.8% in federal capital gains taxes totaling $238,000.
Assume in my above example that the owner of the $1 million asset is a wealthy middle-aged child who has a poorer parent. Provided that the family members can work together, there is an opportunity to eliminate the capital gains tax.
Suppose, for example, that the child transfers the asset into a trust for his parent that pays the income to his poorer parent for parent’s lifetime. At parent’s death the trust contains something known as a “general power of appointment” that allows the parent to direct the disposition of the asset, but if the parent doesn’t so direct then the asset continues on in a generation skipping tax exempt trust to the child and that child’s descendants who originally gifted the asset to the parent.
If parent survives the transfer by at least one year, then on parent’s death the asset would receive a step up in tax cost basis to its current fair market value of $1 million. If the parent then dies, leaving the asset back to the child in trust, and the trustee sells the asset then the original capital gain could be eliminated.
There are issues that must be dealt with for the strategy to be successful. The trust must be drafted in such a way so as to avoid the IRS claiming that the whole transaction is a fraud to evade taxes, so the parent should not be so restricted that he must leave the asset back to the child who made the gift. Along those same lines, if the parent isn’t restricted, then the child may lose the asset in a gift to his or her siblings. These types of issues can be mitigated in several ways. The wealthy child could, as just one example, purchase an assignment of interest from his or her siblings of any assets that parent might leave them from this particular trust.
Another danger is if the poorer parent has any creditors who could have an interest in the assets of the poor parent’s estate. Again, these types of issues must be considered and planned for.
This is just one example. With the increase of both the federal gift and estate tax exemptions, a multi-generational family that shares common goals can work to save estate, gift and income taxes in a number of different ways. I’ll be exploring more of those ways in future columns.
©2014 Craig R. Hersch