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Fix Your Obsolete Estate Plan

Written by: Christopher R. Paul

Co-written by: Melinda Davis, Davis Wealth Advisors

Published in Business NH Magazine (11/2/18)

The Tax Cuts and Jobs Act of 2017 can mean good news for folks standing to inherit property.  Until recently, many people used various estate planning techniques to postpone or avoid the 40% Federal estate tax.  However, as a tradeoff, many of these plans can result in beneficiaries receiving property that is subject to capital gains when sold.  Now that a  taxpayer’s lifetime estate, gift and generation skipping transfer tax exemption is more than  $11 million, most people should no longer need fear (and thus plan for) transfer taxes and can fix obsolete estate plans or create new ones to reduce the capital gains burden on heirs and beneficiaries.  In additional, many revocable trusts created by married couples provide that separate shares are created to avoid estate taxation at the death of the first spouse. Many of these assets that are transferred when a spouse dies will not receive a “step up” in tax basis (the readjustment of the value of an appreciated asset for tax purposes) when the second spouse passes because these assets are not part of their gross taxable estate.  This strategy made sense when the decedent’s gross estate was larger than the lifetime exemption amount.  However, that may no longer be the case with a lifetime exemption of more than $11 million.

Revocable trusts can be amended to provide more flexibility to the trustee/executor to adjust for future estate/income tax considerations when a spouse dies. In addition, many revocable trusts created and funded years ago can be easily modified or terminated to provide for estate inclusion at the death of the grantor or of a beneficiary. 

Making adjustments

Because the “step-up” in basis may now be accomplished with little concern for transfer taxes, seeking ways to create estate tax inclusion has become an integral part of today’s planning process.  One of the first steps is trying to assess the potential transfer tax costs against the income tax savings that would arise from a step-up.

Most people are in a “free base” situation.  That is, the person’s assets are less than his or her lifetime exemption(s).  In these situations, tax basis planning is often a primary component of an estate plan.

For example, in 1998, John died, leaving commercial real estate in a credit shelter trust for the benefit of his wife, Mary, and their children.  By 2018, the commercial real estate appreciated in value to $5,000,000, but John has a low, depreciated tax basis under $200,000.  Upon Mary’s death, the asset will be transferred to their children, none of whom has an interest in owning the real estate.  Unfortunately, the sale would generate over $4,800,000 in taxable capital gain.

However, Mary, having less than $1,000,000 in personal assets, has more than $9,000,000 of remaining lifetime exemption, putting her in a “free base” situation.  This family may wish to consider terminating the trust and distributing the real estate to Mary, or employ a technique to modify the trust to achieve a “step-up” in basis and eliminate $4,800,000 or more of capital gain on the subsequent sale of the appreciated real estate.

Dealing with larger estates

Others may be somewhat in the middle, with combined estates (if married) of between $10 million and $20 million.  Here it gets a bit trickier.  These estates may end up owing federal estate taxes.  The historically large lifetime exemption now in place is scheduled to “sunset” at the end of 2025, essentially cutting it in half.   Moreover, many pundits believe that Congress may give the federal estate tax yet another overhaul prior to 2025.  For these folks, planning with maximum flexibility during one’s lifetime and allowing post-mortem tax planning makes sense.

For example, Jane worked for decades to build a catering business.  Through  careful management and long nights and weekends, she built a thriving business she intends to sell in the next five years.   As a component of her business succession plan, Jane wishes to begin gifting appreciated non-voting interests in her LLC to her children to freeze the value for estate tax purposes.  However, instead of gifting non-voting interests directly in trust for the benefit of her children, she creates an irrevocable grantor trust for the benefit of her elderly mother. The trust is designed such that upon the death of her mother, the interests are distributed in trust for the benefit of her children.   The trust is designed such that the appreciated assets in the trust are “stepped-up” at the death of Jane’s mother, saving both estate taxes at the death of Jane and income taxation on the sale of appreciated assets.

Those couples or individuals who have larger estates in excess of lifetime exemptions can also benefit from both transfer and income tax efficient advanced planning techniques.

For example, in 2010, Peter funded an irrevocable grantor trust for the benefit of his children with $2,500,000 in cash. The trustee of the trust invested in a portfolio of aggressive growth stocks in anticipation of the recovery from the recession.  The risk paid off.  By 2018, the portfolio grew to more than $10,000,000.  Peter is suffering from declining health and wishes to find a way to avoid capital gain recognition when the portfolio is distributed to his children and sold following his death. As with most grantor trusts, Peter retained the power to swap assets of equivalent value with the trustee.  Peter may consider swapping high basis assets such as bonds, other fixed income investments or life insurance for the appreciated portfolio. The appreciated assets, now in his gross estate for transfer tax purposes, will be stepped-up at his death, eliminating or significantly reducing the gain recognized when the securities are subsequently sold.

Change is Always Out There

It is important to remember that things change.  The federal transfer tax regime has been overhauled three times in the past 18 years.  It is a safe bet that it will be again.  The step -up in tax basis may be on the endangered species list.  In his 2012 State of the Union speech, President Barack Obama referred to the “step-up” as the “the single largest loophole in the entire individual income-tax code”.  Former Vice President Joe Biden recently proposed taxing appreciated assets at death as a way to pay for free college tuition, eliminating the step-up loophole.

No one has a crystal ball. Establishing an estate and succession plan with such uncertainty requires careful analysis and, most importantly, flexibility.  What worked in 2000 or 2012 may no longer.  Now is a good time for a check-up, especially for  those who have previously funded irrevocable trusts with now appreciated assets, or married couples with existing revocable trusts more than a few years old.

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