Income Tax and Basis Planning in the Context of Estate Planning Articles
Estate Planning magazine, June 2005
Income Tax Planning Now That Estate Taxes Are Less Significant
Author: JOHN J. SCROGGIN, ATTORNEY
JOHN J. SCROGGIN, AEP, LL.M., of the Georgia and Florida Bars, is a member of the law firm of Scroggin & Company, P.C., in Roswell, Georgia. He is also a CPA. Mr. Scroggin is a nationally recognized speaker and author, and has previously written for Estate Planning. Copyright © 2005, FIT, Inc.
Now that the federal estate tax exemption has increased and the top federal estate tax rate has decreased, income tax planning is likely to become more important to clients. This article explores income tax planning opportunities.
For decades, estate planning has been dominated largely by the desire to avoid a confiscatory federal estate tax. In the early 1980s, the estate tax exemption was $175,000. This amount gradually grew, and the Taxpayer Relief Act of 1997 1 provided for a phased-in increase in the exemption to $1 million by 2006. The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") 2 provided for even higher tax-free transfers. While elimination of the federal estate tax is unlikely, significant estate tax exemptions will probably remain for the foreseeable feature, reducing the federal estate tax confiscation many clients had anticipated at their death.
These changes mean that fewer Americans than at any time in recent history will be subject to federal estate tax. By one estimate, in 2006, less than 1% of all decedents' estates will owe federal estate tax. 3 For the vast majority of Americans, estate planning will no longer be driven by the avoidance of a federal transfer tax. Instead, personal and family concerns and other tax issues will drive the estate planning process.
Nevertheless, the substantial federal estate tax exemptions will be partially offset by higher state estate taxes. As part of EGTRRA, Congress replaced the state death tax credit with a state estate tax deduction. 4 This change will require many states to impose new death taxes-an unpleasant political act. Even if Congress restores the federal state estate tax credit, many states will be reluctant to adopt the higher federal estate tax exemptions. As a result:
- Thirty-eight states which were using the federal estate tax law as the basis of their state estate tax will have to revise their estate tax statutes or incur a significant loss of revenue. 5
- Many states will adopt estate tax exemptions that are lower than the higher federal exemptions, creating a state estate tax when no federal estate tax is due.
- Some states will freeze their state estate tax rate at the pre-EGTRRA federal credit, resulting in a top effective state tax rate of 16% (i.e., the top rate for the previous federal state estate tax credit).
- Some states could adopt inheritance taxes, whereby the tax rate would be determined by the relationship of the decedent to the heir (i.e., the more remote the heir, the higher the tax rate).
- As the federal government did in 1924, more states will adopt a state gift tax 6 to stop the loss of transfer tax revenue through lifetime gifts. 7
- The lack of uniformity in state death taxes will add complexity to estate plans. For example, if a person owns property in more than one state, avoiding the cost and taxes of ancillary probate will become a greater part of the estate plan.
- The pressure to forum shop will increase as taxpayers attempt to move their tax domicile to states-like Florida-that have lower taxes. Florida cannot amend its state estate tax without a constitutional amendment (an unlikely event, given the number of retirees in south Florida). 8
- In the past, many states made little effort to audit the estate tax returns of their deceased citizens. Instead, they relied on the federal government to validate the returns. However, with many states now having lower exemptions than the federal exemptions, states will have to beef up their estate tax audit staffs if they hope to preserve this revenue source.
For most Americans , state and federal income tax planning will trump federal estate tax avoidance. This article will discuss some of the income tax planning opportunities of this new environment.
Income tax planning
Many planning opportunities have been limited by concerns over the avoidance of federal estate tax. When estate tax rates reached as high as 60%, while federal income rates topped out at 39.6%, this concern was certainly valid. But these estate tax restrictions will disappear for the vast majority of Americans, whose tax planning strategies will shift from federal estate tax avoidance to state and federal income tax reduction. Here are some of the possible opportunities.
Income shifting. A client who is funding benefits or obligations (e.g., college tuition or support costs) for someone (e.g., a college age child or a parent in a nursing home) who is in a lower income tax bracket should consider adopting approaches by which the ordinary income or capital gains of the client are shifted to the lower tax rate taxpayer. There are a number of methods for accomplishing this task, including the following: 9
1. Trusts can be created to hold income-producing assets; the trust income is allocated among the beneficiaries based on the trustees' discretion. These "spray trusts" are discussed in more detail later.
2. The transfer of noncontrolling interests in flow-through entities (e.g., limited liability companies ("LLCs"), partnerships, and S corporations) may be used to shift income to lower-bracket family members without giving up control over the underlying asset or the family business. The recent IRS assaults on family limited partnerships ("FLPs") have focused primarily on the estate tax aspects of FLPs. However, for most clients, the federal estate tax issues surrounding FLPs will become moot. FLPs remain an excellent tool for maintaining control of an asset, while income earned from the asset is allocated to lower-bracket family members.
3. A business could hire family members to work in the business. However, if the business owner has earned income over $90,000 (in 2005), then this approach could create Social Security taxes which the business owner would not have incurred. 10
Planning example. Assume a client has a rental property that produces ordinary taxable income of $200,000 per year. The client is in the 35% federal income tax bracket, but his five children and ten adult grandchildren are all in an effective tax bracket of 15%. The client places the rental property in an FLP and retains a 2% general partnership interest. Over two years, he transfers the FLP interests to a spray trust for his descendants using Crummey withdrawal rights to preserve his state and federal estate tax exemptions. The trust has the right to spray income among his descendants. Using the income tax brackets of the 15 trust beneficiaries, the overall federal income tax on his rental property would drop by up to $39,200. 11
Income shifting can also result in changes in the character of shifted income. For example, suppose that a client is a real estate developer. Because the developer is considered a "dealer" in real estate, income from the developer's development of real property will generally be treated as ordinary income. 12 If property were initially acquired by, or transferred to, family members who were not developers, sale of the real estate could be treated as a capital gain transaction.
Income shifting may also be used to reduce the phase-out of tax benefits that apply to many higher income taxpayers. For example, the ability to fund a Roth IRA is phased out for married taxpayers with a modified adjusted gross income of over $150,000. If the shifting of income took the taxpayer below the limits for any applicable deductions or tax benefits, it could provide an additional advantage to the donor.
Income shifting does carry some risks. For example:
- Clients who adopt income shifting strategies should make sure the transactions have economic substance, do not run afoul of the "assignment of income doctrine," 13 and do not result in the IRS' reconfiguring the transaction 14 to avoid the evasion of taxes or to clearly reflect the taxpayer's income. If these doctrines and rules are violated, the client may remain taxable on the income that was supposedly shifted to lower-bracket taxpayers.
- In creating such structures, planners should keep in mind the state income tax ramifications of shifting income. Many states have begun taxing nonresidents on the income distributed from local flow-through business entities. For example, Georgia requires that nonresident owners pay income taxes on the income distributed from some S corporations, partnerships, and LLCs. 15 While forum shopping for estate tax and asset protection purposes has been in vogue for some time, clients may also use forum shopping to minimize any state and local income tax liability.
- Payments of unearned income to beneficiaries who are under age 14 can result in the income taxes being calculated using the parent's income tax bracket, not the child's bracket. 16
- The client must give up the income. In most cases, income shifting makes sense only if the client is willing to forgo future income and/or if the client is already funding a need of a lower-bracket taxpayer (e.g., nursing care costs).
The increased focus on basis. The cost basis of assets generally is stepped up to their fair market value (FMV) at the time of death. The new higher estate tax exemptions frequently mean that less of an estate is subject to federal estate tax. As a result, a quantum shift in tax planning may occur. Instead of lowering the value of assets to reduce transfer taxes, clients may actually want to increase the value of assets to obtain a higher basis step-up. The higher basis will reduce the income taxes paid by heirs on the sale of inherited assets and will create new depreciable values for depreciable assets. 17
Planning example. A chronically ill father owns 40% of a family business worth $3 million. Assume the available estate tax exemption is $2 million and a 40% discount would apply to the father's ownership interest. Also assume there is a 10% control premium. His wife and heirs own the remaining 60% of the business. Wife transfers 11% of the business ownership to the husband as a marital gift. The husband's will provides that the amount of his estate tax exemption equivalent is placed in a spray trust for the benefit of the wife and descendants. If the father dies before the transfer, the value of his interest in the family business would be $720,000 (i.e., $3 million times 40% times 60%). If the 11% interest is transferred, the effective value of the 40% stock interest would be $1,320,000. The creation of a controlling interest creates an additional $500,000 of basis.
It will be a crazy world in which the IRS and tax practitioners will be swapping asset valuation arguments. Moreover, techniques such as intentionally defective grantor trusts will be turned on their heads to become Estate Defective Trusts (discussed later).
Charitable bequests and IRD. When clients want to make a charitable bequest, they should consider funding that bequest with qualified retirement plan assets or other assets that would have created "income in respect of a decedent" ("IRD"). 18 Because of the current rules on naming beneficiaries of retirement accounts, the client is best advised to bifurcate any IRA into an account that names a charity as beneficiary and one or more other accounts that name non-charitable beneficiaries. 19 If the client either does not want retirement assets to go to charity or does not have retirement assets, the will or living trust could provide that any charitable bequest first be funded from IRD assets to the extent the estate or trust held or receives such assets.
Planning example. A client wants to pass $30,000 to a charity at his death. He holds an IRA worth $25,000. The client could name the charity as beneficiary of his IRA and provide in his will that the estate pay to the charity the difference between $30,000 and the IRA value at his death. Assume the IRA was worth $20,000 at death and the client's only heir is in a 40% state and federal income tax bracket. The passage of the $20,000 in IRA funds to charity would save the heir up to $8,000. 20
Investment decisions. Investments in trusts and estates may be changed to investments that are more tax-effective. Net after-tax returns will become a critical part of investment evaluations. For example, fiduciaries will be more prone to use tax-efficient mutual funds and capital gain investments rather than those that may be taxed at higher ordinary income rates, particularly when trusts and estates will be accumulating income.
This trend is already evident in the growth of total return trusts. One motivation for total return trusts is the desire to move away from strict definitions of income and principal that tend to distort fiduciary investment decisions. When fiduciaries are free to make the best economic decisions to produce the highest after-tax return, the net return to all beneficiaries should increase. (Total return trusts are discussed more later.)
Not only the form of the investment (e.g., stocks or bonds), but also the tax vehicle that holds the investment may be important. In an appropriate situation, Roth IRAs, charitable remainder trusts, health savings accounts, 21 Coverdell savings accounts, and Section 529 plans 22 can offer tremendous tax savings.
Planning example. A terminally ill client has an IRA with $100,000 in assets. The client could convert the IRA to a Roth IRA and pass the Roth to heirs. 23 If the client has an estate below the federal exemption equivalent, the Roth IRA will not be subject to federal estate tax, and the growth in the Roth from the conversion date will not be subject to any further income taxes. While the conversion will create an immediate income tax cost to the IRA owner, the tax cost is not paid from the Roth account, reducing the tax depletion of the account. If the client has a net operating loss ("NOL") that was going to disappear at death, the income tax conversion cost of the IRA could be offset by the NOL.
Payment of fees. For most estates, deductions for fiduciary fees will now shift to the fiduciary income tax return. But when a personal representative receives a payment for performing fiduciary functions, that income is taxable at ordinary income rates. However, unless the personal representative is in the trade or business of serving as a fiduciary, the income is not generally subject to Social Security taxes. 24
If an estate will not incur a federal or state estate tax, the payment of fiduciary fees does not generate an estate tax benefit as a deduction, but could increase the income tax burden of the personal representative. In many cases-especially when a trusted heir is going serve as personal representative-the client should consider making a special bequest to that heir. To assure that the heir does not also seek to obtain fiduciary fees, the will could deny personal representative fees to any heir who serves as a personal representative. As further protection, the document might provide that the special bequest lapses if the heir is incapacitated or dead (i.e., the chosen fiduciary cannot serve).
The net effect of using this special bequest is that the estate's taxable income that would have otherwise been offset by a deduction for an executor's fee is now taxable to either the estate or the other beneficiaries. If the personal representative is the only heir, this technique could be of nominal benefit.
Planning for the decedent and his estate
Pre-mortem planning. Although death is often an unexpected event, there are cases in which a terminally ill client can plan for the reduction of his or her taxes. For example, consider the following:
1. The losses of a decedent are not carried over to the estate or heirs. 25 Instead, they simply vanish. There are at least three ways that expiring losses could be used. First, the client (or persons holding a general power of attorney) could take actions to use any expiring losses (e.g., accelerating taxable income). Second, in the case of a married client who files a joint return, the spouse might take pre-mortem actions to create taxable income to offset the soon-to-expire losses. Third, a surviving spouse who is entitled to file a joint return in the decedent's year of death could take year-of-death, postmortem steps (e.g., accelerating income) to offset the losses.
Planning example. Suppose that a client has an NOL of $100,000 and an IRA worth $50,000. The payout of the $50,000 IRA could be substantially tax-free because of the NOL. The client could consider converting the IRA before death to a Roth IRA in order to provide future tax-free income benefits for heirs. If a married client's spouse had a significant retirement plan or IRA, the spouse could withdraw funds from that account before the end of the year of the decedent's death to offset the expiring NOL.
2. Assume that a terminally ill client with a nontaxable estate has a will that makes significant charitable bequests. Making the charitable bequests after the death of the client does not provide any estate or income tax savings. On the other hand, if the charitable transfers were made before death, the income tax charitable deduction could reduce the client's personal income taxes. Make sure the will is rewritten to remove the charitable bequests or, if applicable state law permits advancements, consider making the bequest as a pre-death gift advancement.
Postmortem tax planning for the estate. While a certain amount of postmortem planning has been focused on achieving estate tax savings, much of this focus may shift to reducing income taxes of the estate and its heirs. For example, consider the following strategies:
1. While a trust is generally required to use a calendar year, 26 an estate can elect any calendar or fiscal year of not more than 12 months. 27 By selectively choosing a fiscal year, the planner can effectively lower the overall income taxes of heirs and the estate. For example, suppose that a client dies in October and the estate has considerable income before the calendar year-end. The personal representative could elect to use a January 31 year-end for the estate. With proper planning for any underpayment penalty, the taxes on the income that is distributed to beneficiaries would not be taxable until the April 15 of the following year.
2. If an estate anticipated having large income tax deductions early in its first year, the estate might consider using a longer fiscal year to allow the estate to earn sufficient income to offset the early deductions.
3. The trustee of a "qualified revocable trust" and an executor have the right to elect to treat such a trust as part of the estate. 28 This election can provide living trusts with the unique tax benefits of estates, such as the use of a fiscal year, the limited right of an estate to own S corporation stock, and the two-year waiver of the passive loss rules.
4. Similar planning decisions must be addressed in determining when the estate is to be closed. This decision should be analyzed based on the income tax impact on the beneficiaries. For instance, assume that most of the estate administration has been completed in November, but the tax year of the estate ends in February. If the estate administration is not completed until the following January, the distributable net income ("DNI") of the estate from March through January will not be reported on an heir's tax return until April 15 of the year after the estate was closed. In contrast, if the estate were to be closed in November, two years of the estate's DNI would be reported on the heirs' tax returns (i.e., for the tax year ending in February and that ending upon the closing of the estate in November).
5. It is important to consider not only the tax years of the estate, but also the tax brackets of heirs when making estate or trust distributions. For example, assume in the previous example that an heir was closing the sale of his business in January. The increased taxable income anticipated upon the sale of the business might make it more advantageous to close the estate in November.
6. Because of broad variations in state income taxes, planners should also take into account the relative state income tax brackets of the grantor, the estate or trust, and the beneficiaries. For instance, assume an estate is opened in a state with a fiduciary income tax, but the beneficiaries are all Florida residents. By making income distributions from the estate each year, the potential state income tax could be reduced or eliminated.
7. The timing of payment of deductible expenses is also a critical income tax planning issue. Most estate administration deductible expenses are not considered business expenses. Therefore, they cannot generate an NOL for the estate. Consequently, to the extent that such deductions exceed income, they are not carried over to future years.
However, the Code provides that to the extent estate deductions exceed the estate's income in the final year of the estate, the excess deductions can be carried over to the estate beneficiaries. 29 Hence, personal representatives of cash basis estates with substantial deductible expenses (such as commissions and legal fees) should consider delaying the payment of non-business deductions until the final year of the estate, so that heirs can receive the benefit of the pass-through of the excess deduction. Personal representatives should also be careful about paying too many non-business expenses in any year in which the estate has insufficient income to offset the deduction of such expenses.
8. The bases of depreciable estate assets are generally stepped up to FMV at the time of death. Because the estate is a new taxpayer, the estate can elect whatever new depreciation method it deems appropriate to reduce income taxes. The estate is not bound by the depreciation methods that the decedent used.
9. If an estate or trust sells an asset, receives an installment note, and then distributes the note to a beneficiary, the distribution of the note may trigger recognition of the inherent gain in the note, resulting in income taxation to the distributing trust or estate. 30 If a distribution to heirs proximate in time to the sale is anticipated, and the sale is expected to result in a significant recognized gain, it would be far better to distribute the asset to the beneficiary prior to the sale, permitting deferral of the gain over the term of the note.
10. Traditionally, the use of disclaimers in postmortem planning has focused primarily on minimizing estate taxes. Now that federal estate taxes are less of an issue, tax planning will refocus on using disclaimers to minimize income taxes.
Planning example. A grandparent dies with an IRA worth $100,000. The sole heir has four children in college. Each child is in a 10% income tax bracket, while the parent is in a 40% income tax bracket. If the parent took the IRA funds and used them for the college costs of children, the parent would pay $40,000 in income taxes. If the parent disclaimed the IRA and it passed to the college-attending children, the tax would be only $10,000, saving $30,000 to help cover the cost of college.
Planning for the decedent's final income tax return. Income tax planning also encompasses planning for the reduction of income taxes based on the decedent's final income tax return. 31 The final return is generally due on April 15 of the year after the year of death. Nevertheless, if reasonable cause exists, the personal representative can request up to a six-month extension for the filing of the final return. 32
This planning should focus on the relative income tax brackets of the decedent, the estate, any trusts, and the heirs. By judiciously making elections and allocating income and deductions, the overall tax cost to the heirs can be reduced. However, when the family members have differing goals and tax rates, this planning may create new sources of conflict. Among the tax planning possibilities are these:
- An election may be made to accrue the interest on Series E or EE U.S. savings bonds on the decedent's final income tax return. 33
- The final medical expenses of the decedent can be deducted on the decedent's final income tax return. 34
- Income from partnerships, LLCs, and trusts from the year of the decedent's death must be allocated to the decedent's final income tax return. Thus, decisions about the timing of distributions of income and payment of deductible expenses by the entity or trust, and the allocation of income to the decedent may be part of the income tax planning for the decedent's estate and heirs.
- In certain circumstances, a decedent's final income tax return can be filed as a joint return with the surviving spouse. 35
The impact on the use of trusts
This new tax environment is also changing how clients and planners approach the use and creation of trusts. Trusts remain one of the most adaptable planning tools available. As a result, clients will continue to use trusts to accomplish both tax and nontax estate planning goals. Income tax planning opportunities using trusts will increasingly become part of the estate planning process. Among the expectations are the following:
` Spray trusts.' As discussed earlier, the new tax environment will encourage the allocation of income to lower-bracket taxpayers. The use of a trust spray power to allocate income among various family members (particularly those in lower tax brackets) will be an increasing part of the planning process. Accordingly, a college student who is in a 10% income tax bracket may be sprayed income from a trust, resulting in more after-tax dollars to fund the child's college education. 36
Forum shopping. The income taxation of grantors, trusts, and beneficiaries varies widely from state to state. Even though the tax rate in most states is relatively low, the long-term imposition of a state income tax can amount to substantial tax dollars, especially in states that do not provide any tax break for capital gains. Moreover, the income tax rates on estates and trusts range from zero (e.g., Alaska, Florida) to over 9% (e.g., California, Vermont). 37 Local income taxes could drive the rates even higher. 38 Consequently, clients who are creating trusts (especially trusts that are intended to accumulate dollars) should consider establishing the trusts in a jurisdiction that minimizes local income taxes.
Planning example. A client intends to create a trust, contributing an asset that has a value of $500,000 and a basis of zero. The trust will sell the asset for an installment note payable annually over ten years at 8% interest. The trust is intended to provide for the college education of grandchildren who will not begin college for 11 years. Assume that the grantor's state of domicile will impose an 8% tax on the income and capital gains retained in the trust. The grantor is considering establishing the trust in Delaware-a state that does not impose taxes on trusts that accumulate income for nonresident beneficiaries. If the trust is set up in the donor's state, the state income taxes over the next ten years will be almost $60,000. If the trust were formed in a nontaxable state, such as Alaska, Delaware or Florida, there might be no income tax liability.
Fiduciary income tax issues. Income tax planning will become a higher priority for the majority of estates and trusts. For example, advisors will also need to examine estate and trust investments based on the relative after-tax returns. 39
Planning example. A trustee intends to accumulate trust income for ten years until grandchildren of the grantor reach college age. The trustee has two investment choices: an ordinary income investment that generates an 8% return and a capital gain investment that generates a 6.5% annual return. The trust is in an ordinary income tax bracket of 35%, while the capital gain rate is 15%. Ignoring any other investment or tax issues (e.g., trust deductions, investment risk, diversification, etc.), which is the better investment? The net after-tax yield on the ordinary income investment is 5.2%, while the net after-tax yield on the capital gain investment is 5.5%.
Total return trusts. Investment models no longer fit into a pure allocation between income and principal. States have been adopting statutes that permit existing trusts to be modified to become total return trusts. Based on the number of states that have adopted or are considering adopting total return legislation, the use of these types of trusts should be expected to increase. 40 The acceleration of states' adopting such provisions is at least partially due to the issuance of IRS Regulations 41 which provide that such changes may not cause the trust to lose the benefit of either the marital deduction or the generation-skipping exemption.
Total return trust legislation is directed primarily at correcting unexpected consequences in existing irrevocable documents. However, trust instruments can adopt similar approaches, without having to comply with the restrictions of a state statute. For example, the unitrust amount set forth in most state statutes is 3% to 5%. A client might provide that an annual trust distribution is to equal all the income from the trust, but not less than 8% of the value of the trust assets.
Exposure of fiduciaries to liability. The failure of a fiduciary and the estate planner to plan properly for the estate or trust and a beneficiary's tax liability may expose fiduciaries and planners to new liability claims. 42 Moreover, the conflicting tax rates and diverse goals of beneficiaries may place fiduciaries in the untenable position of being asked to manage family conflicts concerning the tax aspects of the estate or trust's investments and the tax elections.
As a result, planning for estates and trusts will increasingly include ways to minimize the liability of fiduciaries who are acting in good faith. 43 The terms may include revising the standard of fiduciary liability in the applicable instruments, broadly indemnifying fiduciaries and liberal payment of any legal fees incurred by fiduciaries acting in good faith.
Estate Defective Trusts. For years, clients and planners have used intentionally defective grantor trusts, which cause the trust's income to be taxable to the grantor while the transfer of assets to the trust is complete for estate tax purposes. The objective of such trusts, which I will refer to as "Income Defective Trusts," is to reduce a client's federal estate taxes. 44 An Income Defective Trust uses the differences in the income tax and estate tax rules 45 to create a trust that remains taxable to the grantor for income tax purposes (pursuant to Sections 671-678), while the trust assets are removed from the grantor's taxable estate.
However, with the recent increases in the applicable exemption amount (and with more increases still to come), the gap between the income tax and transfer tax rules may create planning opportunities for "Estate Defective Trusts" ("EDT"). 46 Such trusts are intentionally created to have the trust income taxable to the trust or its beneficiaries, but to have the trust assets remain in the grantor's taxable estate.
An EDT has two major income-tax-related benefits. First, the tax on the income of an EDT is allocated to either the trust or its beneficiaries. Unlike an Income Defective Trust, the EDT can effectively permit a grantor to use the lower income tax brackets of the trust beneficiaries to reduce the overall taxes of the family.
Planning example. A client has a grandchild in college, and the client owns an asset that generates an annual income stream of $40,000. The client is in an effective income tax bracket of 40%, while the grandchild is in an effective income tax bracket of 15%. Using an EDT, the family saves $10,000 in annual income taxes. 47 If the grantor were paying Social Security or self-employment taxes (e.g., by being the manager of an LLC), the savings would be even more significant.
Not only are income taxes reduced, but the after-tax proceeds from the income are not includable in the grantor's estate, reducing the possibility that the grantor may be subject to either state or federal transfer taxes.
Planning example. Assume in the above example that the client dies in 20 years, but retained the asset that generated $40,000 in annual income until his death. Assuming an annual 6% return, the annual after-tax income (even at a 40% income tax rate) from the asset could create an additional estate value of over $685,000 at the grantor's death.
Second, many clients hold low-basis assets (e.g., a family farm or business). The client may desire to gift the asset to family members, but does not want to lose the benefit of the step-up in basis which occurs at death. The client can place the asset in an EDT. Beneficiaries will receive the current benefit of the asset, but the asset will remain part of the grantor's taxable estate, permitting a step-up in basis.
Planning example. A client owns a business that has a zero basis, but is worth $500,000. The business is growing at an annual rate of 5%. The client's son is taking over the business. If the father gifted the asset to his son, the son would take over the father's zero basis. Assume the father dies in five years, when the business is worth $640,000. By placing the business in an EDT, if the son sold the business when he was in a 20% effective tax bracket, he would save $128,000 because of the EDT.
Benjamin Franklin said that only taxes and death are inevitable. As long as we have taxes, tax avoidance will remain an important motivation for many clients. With federal death taxes no longer affecting the vast majority of clients, the avoidance of state and federal income tax and state death taxes is becoming the prime focus for tax planning.
Instead of lowering the value of assets to reduce transfer taxes, clients may actually want to increase the value of assets to obtain a higher basis step-up. The higher basis will reduce the income taxes paid by heirs on the sale of inherited assets and will create new depreciable values for depreciable assets.
Pub. L. No. 105-34.
Pub. L. No. 107-16.
See Godfrey, "U.S. Senate Endorses Plan to Speed Cut of Estate Tax," Wall Street Journal (3/21/03).
See Gans and Blattmachr, "Quad partite Will: Decoupling and the Next Generation of Instruments," 32 ETPL3 (Apr. 2005); Steiner, "Coping With the Decoupling of State Estate Taxes After EGTRRA," 30 ETPL 167 (Apr. 2003); Woods, "Decoupling Dilemma," 143 Tr. & Est. 50 (Apr. 2004); Godfrey, "The Phaseout of the Federal State Death Tax Credit," 35 Tax Advisor (Feb. and Mar. 2004); McNichol, "Assessing the Impact of State Estate Taxes," Center on Budget and Policy Priorities (2/18/04), available at www.cbpp.org/2-18-04sfp.htm.
For example, Florida in 1999 received almost $650 million from the credit. Unless other sources of revenue are located, Florida (which has no income tax) could face severe budgetary problems.
As of 12/31/03, only Connecticut, Louisiana, North Carolina, and Tennessee have a state gift tax.
See Stetter, "Deathbed Gifts: A Savings Opportunity for Residents of Decoupled States," 31 ETPL 270 (June 2004).
Surkin, "The Impact of the Decoupling of State Estate Taxes on a Taxpayer's Choice of Domicile," 101 J. Tax'n 49 (July 2004) .
See Westfall and Mair, Estate Planning Law and Taxation , ¶10.02 (Warren, Gorham & Lamont).
I.e., in 2005, above the $90,000 wage base, the combined employer and employee Social Security rate drops to 2.9%, a rate savings of 12.4% when compared to the combined 14.3% tax rate on earned income below the wage base.
I.e., $200,000 per year times the 98% limited partnership interest times the 20% difference in tax rates.
Section 1221 provides that capital gain treatment is not available for property held "primarily for sale to customers in the ordinary course of business."
See Lucas v. Earl, 8 AFTR 10287 , 281 US 111 , 74 L Ed 731 , 2 USTC ¶496 (S.Ct., 1930), and Helvering v. Clifford, 23 AFTR 1077 , 309 US 331 , 84 L Ed 788 , 40-1 USTC ¶9265 (S.Ct., 1940). For an excellent discussion of this topic, see Westfall and Mair, supra note 9, at ¶10.01[a].
Cf . Ga. Code Ann. §48-7-129.
For more information on this topic, see Scroggin, "Brave New World of Basis Planning," 144 Tr. & Est. (Apr. 2005).
Section 691(c). See Schlesinger and Mark, "Charitable Estate Planning With Retirement Assets," 28 ETPL 390 (Aug. 2001), and Maydew, "How the Courts Interpret Income in Respect of a Decedent," 92 J. Tax'n 41 (Jan. 2000) .
Schlesinger and Mark, supra note 18.
This example ignores the possible benefit of using a "stretch IRA" or other techniques to provide long-term deferral benefits to an heir. See Guglielmo, Wave, and Hamilton, "Managing the Tax Consequences of Large IRAs: The Emergence of Integrated Solutions," J. Practical Est. Plan. (Nov. 2002).
Leimberg and McFadden, "Health Savings Accounts-An Important New Tool for Estate Planners," 31 ETPL 194 (Apr. 2004); Baum, "The Advantages of Health Savings Accounts-the Code's Newest Healthcare Arrangement," 100 J. Tax'n 101 (Feb. 2004) .
Schlesinger, "Qualified State Tuition Programs: More Favorable After 2001 Tax Act," 28 ETPL 412 (Sept. 2001); Fox and Root, "New Dimensions in Education Planning," J. Practical Est. Plan. (Aug./Sept. 2001).
Steiner, "Eight Reasons to Convert to a Roth IRA," J. Retirement Plan. (May/June 1998); Rotenberg and LaVangie, "To Roth or Not to Roth," J. Retirement Plan. (Jan./Feb. 2004).
Rev. Rul. 58-5, 1958-1 CB 322, and McDowell v. Ribicoff, 8 AFTR 2d 5016 , 292 F2d 174 , 61-2 USTC ¶9514 (CA-3, 1961). But see Ltr. Rul. 9107009 , where the fiduciary fees paid to an attorney who served as a fiduciary for 12 trusts were considered self-employment income.
Rev. Rul. 74-175, 1974-1 CB 52 .
Sections 441-443 and Section 645(a).
Section 645. Dennett and Moseley, "Maximizing the Benefits of the Section 645 Election," 31 ETPL 546 (Nov. 2004).
Section 453B. If the installment note was obtained by the holder before death and was transferred as a result of the death of the holder, a non-sale transfer is not a taxable disposition. See Section 453B(c). However, if the note is returned to the obligor of the note, the estate is taxable on the remaining gain. See Section 691(a)(5).
For a thorough examination of this topic see, Kasner, Post Mortem Tax Planning , "Elections That Affect Income and Deductions in the Decedent's Final Income Tax Return," §2.02 (Warren, Gorham &Lamont).
Section 454(a) permits accrual of the interest on certain non-interest bearing bonds, but is not limited to U.S. savings bonds.
Kamm, "Discretionary Trust Distributions-A People Oriented Approach; How to Help Our Clients Make Informed Decisions," ABA Section of Real Property, Probate and Trust Law, 10th Ann. Est. Plan. Symposium, vol. 3 (May 1999).
Schoenblum, 2004 Multistate Guide to Estate Planning , Table 12 (CCH 2004).
E.g., New York City imposes an income tax at a rate of 3.2.%. Id .
VanDenburgh, Harmelink, Crumbley, and Apostolou, "Investment and Tax Considerations for Capital Preservation," J. Retirement Plan. (Nov./Dec. 2002).
At least 40 states have adopted or are considering adopting total return trust legislation.
Reg. 1.643(b)-1 .
Merric, Gillen and Freeman, "Malpractice Issues and the Uniform Trust Code," 31 ETPL 586 (Dec. 2004); Abendroth, Bieber, and Hodgman, "Managing the Risk of Liability in an Estate Planning Practice," 30 ETPL 373 (Aug. 2003).
Kurlander, "Enhancing the Protection and Independence of Fiduciaries," 31 ETPL 448 (Sept. 2004); Raithel, "Drafting Estate Planning Provisions to Avoid Litigation," 27 ETPL 55 (Feb. 2000); Richwine, "How Individual Trustees Can Avoid Liability and Breaches of Trust," 24 ETPL 481 (Dec. 1997).
Cushing, "Planning with Intentional Grantor Trusts," ALI-ABA Sophisticated Estate Planning Techniques, Boston (9/17/92); Roth, "The Intentional Use of Tax-Defective Trusts," 26 U. Miami Heckerling Inst. on Est. Plan . §400 (1992); Zaritsky, Tax Planning for Family Wealth Transfers , ¶3.02 (Warren, Gorham & Lamont 1991); Zaritsky and Lane, Federal Income Taxation of Estates and Trusts , ¶7.03[3 (Warren, Gorham & Lamont); Irizarry-Diaz, "How Defective Is Your Trust? Suggestions on Structuring an Intentionally Defective Grantor Trust," 41 Tax. Mgmt. Memo. No. 13, 231 (6/19/00).
Huffaker and Kessel, "How the Disconnect Between the Income and Estate Tax Rules Created Planning for Grantor Trusts," 100 J. Tax'n 206 (Apr. 2004) .
See Scroggin, "The Estate Defective Trust," Taxes (Jan. 2005 .
I.e., $40,000 times the 25% difference in tax brackets.
The Increased Importance of Basis Planning
Published in Trusts and Estates Magazine, April 2005
By: John J. Scroggin, AEP, J.D., LL.M.
Copyright, 2005. FIT, Inc.., All Rights Reserved.
For decades, estate planning has been largely dominated by techniques designed to minimize a confiscatory federal estate tax. However, higher exemption levels created by Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) have significantly reduced the number of Americans who are subject to a federal estate tax. Currently, roughly 2% of all estates are taxable and in 2009, it is expected that less than 0.3% of all estates will be subject to an estate tax.  Tax planning for most Americans will shift from a focus on federal transfer tax avoidance to a focus on income tax avoidance  and state estate tax minimization. The potential (but unlikely) permanent elimination of a federal estate tax will only increase the focus on basis planning.
A New Perspective
While basis issues have always been an aspect of global planning, the income tax benefits derived from basis planning were often eclipsed by the need to minimize a confiscatory federal transfer tax. With the transfer tax less of an issue for most Americans, planning for the basis of assets is receiving new attention.
For example, much of the conflict between tax practitioners and the IRS has focused on the undervaluation of assets. That world is getting ready to dramatically change. With a significant reduction in the number of taxable estates, the IRS and tax practitioners may swap valuation arguments. When there is no federal estate tax due, practitioners may want to increase the fair market value of assets to obtain a greater step-up in basis.  Meanwhile, the IRS will challenge techniques which create a higher values to reduce the potential income tax savings of a higher basis.
Planning Example : Assume that in 2006, a terminally ill client owns 40% of a business having a fair market value of $4.0 million. The estimated valuation adjustments are 30%. The client's sole heir owns the remaining 60% of the business. The client's remaining assets are $200,000. If the client dies, the basis step-up in the 40% business interest would be $1,120,000. Assume instead, the client purchases a 15% minority interest from the heir for a note for $420,000. At the client's death, his 55% interest is worth at least $2.2 million. The note and remaining assets would produce a non-taxable estate of $1,980,000, while providing a step up in basis for the 55% interest to $2.2 million. Assuming the heir sold the business after the client's death, the new step-up in basis would save up to $216,000 in capital gain taxes, assuming a 20% applicable rate . 
Estate Defective Trusts . The gap  between the income tax and transfer tax rules may create new planning opportunities for Estate Defective Trusts ("EDT").  Such trusts are purposely designed to have the trust income taxable to the trust or its beneficiaries, but to have the trust assets included in the grantor's taxable estate. Do you remember Clifford Trusts?
An EDT has two principal income-tax-related benefits. First, the tax on the income of an EDT is allocated to either the trust or its beneficiaries. Unlike an Income Defective Trust, an EDT permits a grantor to shift income to trust beneficiaries with lower income tax brackets and reduce the overall income taxes of the family (e.g., to fund a grandchild's college education or support an elderly parent).
Second, many clients hold low-basis assets (e.g., a family farm or business). The client may want to gift the asset to family members, but does not want to lose the step up in basis which occurs at death. Instead, the client can place the asset in an EDT. Beneficiaries will receive the current benefit of the asset, but the asset will remain part of the grantor's taxable estate, permitting a step-up in basis at the grantor's death.
Planning Example : Assume a client owns a business with has a zero basis that is worth $1,000,000. The business is growing at an annual rate of 5%. The client's son is taking over the business. If the father gifted the business, the son would receive the father's zero basis. Assume the father dies in five years, when the business is worth $1,280,000. By placing the business in an EDT, the son obtains a basis of $1,280,000 for sale and, if applicable assets are depreciable, for depreciation purposes.
The rules governing EDTs are extraordinarily complex and offer many traps for the unwary. Practitioners should consider such trusts only after having developed a through understanding of the estate, gift and income tax rules which impact EDTs.
Redemption Agreements vs. Cross Purchases . If a C corporation owns an insurance policy to fund the redemption of a deceased shareholder's stock , the corporate redemption does not provide any income tax basis adjustment to the surviving shareholders.  However, if the surviving shareholders own the policy, they receive an increase in their income tax basis in the acquired shares.
Planning Example : Assume three shareholders of a C corporation insure each of their lives for $2,000,000 to fund a buy-sell agreement. Shareholder A dies. If the corporation owns the insurance and carries out the redemption of A's shares, the remaining shareholders receive no step-up in the tax basis in their stock. However, if the remaining shareholders own the insurance and use it to acquire the deceased shareholder's shares, each shareholder receives a $1,000,000 increase in the income tax basis in the acquired stock, even though they own exactly the same percentage of stock as they would have owned if the corporation had redeemed the stock.
Discounting Values . A significant part of estate planning over the last several years has been the use of techniques designed to reduce the fair market value of gifted or bequeathed assets. However, techniques which reduce the fair market value of an asset may also reduce its potential basis. If the gifted asset's basis exceeds the asset's fair market value, the lower fair market value will be the donee's basis. If a bequeathed asset's fair market value is reduced, the lower fair market value will become the heirs' new basis.
This issue creates an interesting potential problem for advisors. If the client expects to be subject to a state or federal estate tax in the near term, the use of discounting techniques may be advisable. However, what happens as the federal estate tax exemptions increase and the federal taxable estate is non-taxable or if there is only a state death tax due and the state death tax rate is less than the combined state and federal income tax rate? If the practitioner has not advised the client about the possible adverse income tax results of a loss of basis, heirs could try and hold the practitioner liable for the use of a technique which, in hindsight, was unnecessary for estate tax purposes and actually produced an unacceptable income tax cost to the heirs.
Lifetime Basis Issues
In general, the donee of a gifted asset takes over the tax basis of the donor. IRC section 1015(a) provides: If the property was acquired by gift ..., the basis shall be the same as it would be in the hands of the donor ... except that if such basis ... is greater than the fair market value of the property at the time of the gift, then for the purpose of determining loss the basis shall be such fair market value . The result of this rule is that the donor's appreciation on the gifted asset will normally be taxed to the donee and the reduction in the value of gifted asset may be lost as a tax benefit.
When federal estate tax avoidance was the paramount tax concern, it generally did not make sense to make annual exclusion gifts of low basis assets, because the estate tax avoidance value of the annual exclusion was reduced by the income tax liability which shifted to the donee. For example, assume a donor gifts a zero basis asset using an $11,000 annual exclusion. The value of the gift (at an assumed capital gain rate of 20%) was effectively diminished by the $2 , 200 in income taxes. To provide the maximum reduction in estate taxes, it was generally better to have the donor sell the asset, pay the capital gain taxes and gift $11,000 in cash.
However, if the donor does not have a taxable estate, the gifting of low basis assets may provide an overall tax savings. Assume a married client has three children in college. The client owns a stock worth $61,000, with a basis of $1,000. The client is in an effective state and federal capital gains bracket of 20%, while the children are in a 5% bracket. If the client sells the stock, the net-after-tax proceeds are $49,000. If the children sell the stock, the after-tax proceeds could be $58,000. Moreover, benefit of the transfer of capital assets may become even more pronounced when the capital gain rate potentially reaches 0% in 2008.  Using the facts in the above example, the tax savings would be $12,000.
If the donor's basis in the asset exceeds its fair market value, the rules get a little more complicated for the donee. If the donee subsequently sells the asset for a gain, the donee uses the donor's basis in the property.  If the donee sells the asset for a loss, the fair market value of the donated assets is used as the basis. Thus, if the donee sells for a price between the fair market value and the donor's basis, neither a loss nor a gain is incurred.  Unlike a gift, the basis of an asset transferred at death is the asset's fair market value, even if the fair market value is lower than the asset's date-of-death basis.
Planning Example : Assume a terminally ill married client owns an asset with a basis of $500,000 and a fair market value of $200,000. If the client dies, the asset's basis will step down to its fair market value, resulting in the termination of the tax benefit of the inherent loss in the asset. Instead, the terminally ill client could gift the asset to a spouse. If the spouse subsequently sells the asset for a value from $200,000 to $500,000, no taxable gain will be reported on the sale.
Planning Example : Assume a client owns marketable stock she purchased for $14,000 which is now worth $10,000. If the stock is gifted to a child and the child sells it for $10,000, the $4,000 capital loss is effectively lost. Instead, have the client sell the asset for $10,000 and take a $4,000 capital loss. The $10,000 in cash proceeds could then be gifted to the child.
Step-Up in Basis at Death
To the extent assets are includible in a taxable estate, the assets generally obtain a step-up in basis to the assets' fair market value determined at either the date of death or the alterative valuation date.  There are a number of exceptions to the step-up in basis rules, including property which constitutes income and respect of a decedent("IRD"),  S corporation stock to the extent assets of the S corporation would have constituted IRD if held directly by the deceased shareholder,  and, according to the IRS, net unrealized appreciation in employer stock distributed from a qualified retirement plan before the death of the participant. 
If the asset was acquired by the decedent within one year of death and is bequeathed to the donor or a spouse, the decedent's basis in the asset does not step-up to its fair market value. Instead, the beneficiary takes the decedent's basis.  The legislative history of section 1014(e) and IRS rulings  indicate that a bequest to a trust in which the original donor is also a beneficiary may be deemed an indirect transfer which would deny a basis step-up. 
Planning Example : A client's wife is terminally ill, but owns no assets. In 2005, the donor transfers $1,500,000 in low-basis assets to the spouse, who revises her will to provide that those specific assets pass into a bypass trust. If the wife dies within one year, the donor/spouse can disclaim his interest in the trust and the assets will step-up to their fair market value, saving taxes for the children. If the wife survives the transfer by one year, the step-up occurs and the disclaimer is unnecessary. In the alternative, the husband could create a trust over which the wife has a general power of appointment. Arguably, the general power of appointment is not a gift and, therefore, section 1014(e) would not apply. 
A Few Other Planning Ideas
Marital Bequests . Even in a taxable estate, if an estate tax is deferred during the surviving spouse's lifetime, clients should consider adopting a strategy that increases the basis of assets, particularly if the surviving spouse is expected to survive long enough to use a higher federal estate tax exemption. Because no tax is due at the death of the first spouse, increasing the basis can decrease the income taxes imposed on the surviving spouse when assets are sold. Although the higher basis could raise issues of valuation upon the death of the surviving spouse, these issues may be mitigated by the sale of the assets, the depletion of the asset to support the surviving spouse and the increased federal estate tax exemption for the surviving spouse.
Divorce . The basis of assets transferred as a result of divorce should be an important part of the divorce negotiating process. The following general rules apply to transfers incident to a divorce:
Lifetime, non-taxable divorce-driven property transfers between spouses result in the recipient spouse receiving the basis of the transferor. 
If property transferred directly to an ex-spouse has a liability in excess of its basis, no recognition occurs on the transfer and the recipient spouse takes the transferor spouse's basis.  Transfers in trust for an ex-spouse do not receive this favorable tax benefit.
If the property is passive activity property, any suspended passive activity losses for the property may be added to the basis of the property. 
Although the basis in most gift transfers is the lesser of the asset's fair market value or its basis, this limitation is not applicable to divorce or separation transfers.  The transferee spouse will take the transfers basis even if the basis is greater than the asset's fair market value.
The holding period of the transferor spouse carries over to the transferee spouse. 
Divorce negotiations should take into account the after-tax value of an asset, not just its fair market value. For example, assume a divorcing client has a choice between $1.0 million in cash or $1.1 million in stock which has a basis of $1,000. Which is the better option? For tax purposes (assuming an immediate stock sale), the $1.0 million in cash is a better choice. Assuming a capital gains rate of 20%, the $1.1 million is stock carries an inherent tax cost of roughly $220,000. Therefore, the asset has a true after-tax value of only $880,000.
Choice of Entity . Clients who are examining the type of business entity to use should consider the effect of the death of the business owner on the basis of the business assets. For example, assume the client wants to create a flow-through business entity. Entity choices include partnerships, LLCs and S corporations. However, upon the death of the business owner, LLCs (which are taxed as partnerships) and partnerships permit a step-up in basis in the value of the assets inside the business entity.  There is no similar provision for an S corporation.
Planning Example : Assume a decedent owned 99% of a general partnership that held an asset worth $500,000, which had a basis of $1,000. Assuming there are no discounts on the value of the partnership, the basis in the partnership asset could increase to $495,000, eliminating significant taxes on the sale of the asset. If the same asset where held in an S corporation, the corporation's basis in the asset would remain $1,000.
Practitioners should strongly encourage clients to obtain appraisals of estate assets which are not readily marketable even when an estate tax return is not due. Advisors need to make sure they have adequately advised their clients on the impact on basis of any techniques used in the estate plan. Finally, it is advisable to provide directions and protections to fiduciaries on how basis issues, allocations and elections should be handled.
As income tax planning begins to trump federal estate tax avoidance, clients and advisors will increasingly focus their attention on how planning techniques impact the basis of the assets in the estate plan.
Author : John J. Scroggin, AEP J.D., LL.M. is a graduate of the University of Florida and is a nationally recognized speaker and author. Mr. Scroggin has authored over 300 published articles, outlines and books. He has been quoted extensively, including in Forbes, Fortune, the Wall Street Journal, Kiplinger's, Money Magazine and Newsday.
 Pub. L. 107-16. Tax legislation in 2005 may contain even greater increases in the exemptions.
 See: Godfrey, "US Senate Endorses Plan to Speed Cut of Estate Tax," Wall Street Journal, March 21, 2003.
 Scroggin, "Does Income Tax Planning Trump Estate Tax Planning," scheduled for publication in the Estate Planning Journal, June 2005.
 However, the cost of the imposition of new state death taxes may serve as a partial tax offset to the benefits of a higher income tax basis.
 However, there could be a income tax cost to the heir who sold the 15% interest.
 Huffaker and Kessel, "How the Disconnect Between Income and Estate Tax Rules Created Planning for Grantor Trusts," Journal of Taxation, April 2004.
 Scroggin, "The Estate Defective Trust," Taxes, January 2005. The author is completing a more detailed analysis of Estate Defective Trusts entitled "The Nuances of Estate Defective Trusts," to be published in the Journal of Taxation this summer.
 If the business operates as an S corporation, section 1367(a) may provide for a basis adjustment for all shareholders, including the decreased shareholder.
 Robinson and Rappaport, "Impact of Valuation Discounts on Estate and Income Tax Basis," Estate Planning Journal, June 1997.
 e.g., as the exemptions phase-in under EGTRRA, or if there is a substantial increase in exemptions under any 2005 tax legislation.
 Or the client moves to a non-taxable state such as Georgia or Florida.
 For an article which addresses drafting and planning for changes in basis planning, see: Berall, Harrison, Blattmachr, and Detzel, "Planning for Carryover Basis that Can Be/Should Be/Must Be Done Now," Estate Planning Journal, March 2002.
 This assumes the applicable tax laws are not modified before 2008.
 Treasury Regulation section 1.1015-1(a)(1).
 Treasury Regulation section 1.1015-1(a)(2)
 IRC section 1014(a) and Treasury Regulation section 1.1014-3.
 IRC sections 1014(c) and 691.
 IRC section 1367(b)(4). A similar rule applies to partnerships. See Treasury Regulation 1.742-1.
 Revenue Rulings 75-125, 1975-1 CB 254.
 I RC section 1014(e)
 See PLRs 9321050 and 9026036.
 For a detailed review of this issue, see Zaritsky, Tax Planning for Family Wealth Transfers (WG&L), section 8.07
 See IRC section 1041(a)(2) & (c)
 See. Treasury Regulation section 1.041-1T(d) Q&A 12 and PLR 9615026.
 IRC section 469(j)(6) and 1041(b).
 See IRC section 1041(b)(2).
 IRC section 1041(b)(1) and 1015.
 IRC section 754. See: Markstein, "Postmortem Estate Planning with Limited Partnerships," Estate Planning Journal February 2004.
 See: Hodgman, "Carryover Basis: Planning and Drafting Issues," Estate Planning Journal, December 2001 for language which might be used to protect the fiduciary.
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