With the large federal estate tax exemption, many believe that estate planning is no longer as important as it once was. Quite to the contrary, estate planning today is more important than ever. There are many non-tax reasons to ensure that your hard earned assets end up with your loved ones protected from the reaches of divorcing spouses, creditors, predators, as well as in a tax efficient manner.
While federal estate taxes don’t affect as many as it once did, income tax planning built into your estate plan can mean the difference between your spouse and other loved ones paying large amounts, or even nothing at all.
More on that in a moment.
I recently returned from my 27th year attending the country’s largest and best estate planning conference conducted by the University of Miami’s Heckerling Institute. Unlike other areas of the law, keeping up with the myriad of changes to our nation’s tax laws requires annual diligence. Since I’m board certified in wills, trusts, and estates, I also must complete more than 120 hours of high level continuing legal education in my field every reporting period.
This year, the academic lecturers stressed the importance of planning for tax cost basis. Let me explain by example. Suppose you purchased ABC Stock at $1/share. That is your “tax cost basis”. Suppose the years the value of the stock increased to $11/share. If you sold the stock at $11/share, you would report a capital gain of $10/share ($11 selling price less the $1 basis) and likely pay 20% capital gains tax.
If you were to gift that stock to your daughter during your lifetime, she takes the same tax cost basis in the stock that you would have. So if she sells the stock at $11/share, she would also report a $10/share capital gain and pay capital gains tax.
If instead of gifting the shares to your daughter during your lifetime, you left them to her in your will or revocable trust at your death, the tax cost basis of the stock increases to $11/share. If she sells the stock at that price, she reports no capital gain.
Seems pretty simple. But it’s not.
Many estate plans build in trusts for spouses, so that at the death of husband, for example, the trust continues on for wife for her lifetime. When wife dies then the trust may distribute to children. When the estate tax exemption was lower, it was important to exclude the husband’s trust benefiting wife from wife’s estate.
That strategy no longer works, largely because it does not result in a second increase in tax cost basis when wife dies, resulting in unnecessary capital gains taxes. Those taxes may be quite high depending upon the appreciation that occurs between husband’s death and wife’s death. The longer that time period, the greater likelihood that the couple’s financial and real estate portfolio increases significantly in value.
The trust for wife may be important, however, to protect the intended distribution to her and then to the children. Without it, if wife remarries, her new spouse may have rights to these assets. So it’s important to build the trust in such a way to protect the assets from this danger while achieving the intended tax planning. This isn’t always as easy as it sounds.
Consider, for example, that in order to achieve the increase in tax cost basis on the second spouse’s death, not only will the assets that increase in value be adjusted, but so will the assets that decrease in value. This is because the tax law is written to adjust the new basis to the date of death fair market value.
Let’s return to my example where husband left a trust for wife. Assume further that at wife’s death some of the stocks in the portfolio increased by $10/share while other’s decreased by $5/share at the time of wife’s death. Assume further that one of their homes increased in value by $150,000 between the time of their deaths and the other home decreased in value by $50,000.
Without sophisticated planning, not only will the increases adjust when the children inherit the assets, but the decreases will adjust as well, resulting in the potential larger capital gains taxes when those assets are sold. It is possible to draft a will or a trust instrument that would only adjust the basis to the value of the assets that increased, while leaving the decreased basis alone. How that’s done, and whether that strategy is right for a particular client is beyond the scope of this column.
This is but one tax saving strategy that can be considered when planning a client’s estate. There are dozens of others. And, as I wrote at the onset of this column, there remain many non-tax reasons to plan an estate.
I’ll be writing about other income tax saving strategies in future columns. If you haven’t revisited your estate plan in the last couple of years, now is the time to do so. The methods estate planners used to save taxes under the old law when the federal exemptions were lower may actually result in more taxes than necessary under today’s law.
© 2019 Craig R. Hersch. Originally published in the Sanibel Island Sun.