As the federal estate tax exemption has ballooned from $5 million in 2011 to $13.99 million today, the need for estate tax planning has drastically decreased. However, with a top marginal income tax rate of 37 percent, the focus of estate planning has shifted to a new frontier: income tax basis planning.
The Basics of Income Tax Basis
In its simplest form, income tax basis—often referred to simply as basis—is the original cost to buy an asset (i.e., stock, bond, real property). However, the actual definition is more complex, as basis can be adjusted over time and depends on how an asset was acquired. Basis must be tracked because, when an asset is sold, income tax liability in the form of capital gains tax is assessed on the capital gains, which is calculated by subtracting the basis from the sales price. Basis plays an important role in estate planning in two ways:
- Carry-over basis. When property is gifted during life, the recipient of the gift receives the donor’s basis in the property, referred to as carry-over basis. For example, if you purchase 100 shares of Facebook stock for $60 per share for a total of $6,000, your basis in the stock is $6,000. If you then gift the stock to your son during your lifetime when the price is $100 per share, your basis of $6,000 “carries over” to your son so that his basis in the stock is $6,000 (even though the fair market value is $10,000). If your son decides to immediately sell the stock for the fair market value, capital gain of $4,000 ($10,000 fair market value less the $6,000 basis) will be subject to capital gains tax.
- Basis a When property is transferred at death, the beneficiary generally receives a basis in the property equivalent to the fair market value on the date of the decedent’s death—a concept known as basis adjustment. Because property tends to appreciate in value and the fair market value of the asset at the date of the decedent’s death is usually more than the decedent’s original basis, most basis adjustments can be referred to as a step-up in basis. For example, if you purchase 100 shares of Facebook stock for $60 per share, your basis is $6,000 (as in the earlier example). However, instead of gifting the stock during your lifetime, you leave it to your son at your death when the stock is worth $100 per share. In this case, the stock receives a step-up in basis, and your son’s basis becomes $10,000, reflecting the fair market value at the time of your death. If your son decides to immediately sell the stock for the fair market value, the sales price will equal your son’s basis, so there will be no gain and no capital gains tax.
AB Trust Planning: An Income Tax Basis Nightmare for Many Couples
Including assets in a deceased person’s estate is the key to giving beneficiaries an adjusted basis. Yet traditional planning for married couples that uses an AB trust plan deliberately excludes property from the surviving spouse’s estate. An AB trust plan, also known as a marital or QTIP trust, family trust, or bypass trust plan, works as follows:
- When the first spouse dies, the deceased spouse’s property will be divided so that an amount equal to the federal estate tax exemption will go into the bypass trust (the B trust), and any excess will go into the marital trust (the A trust). For example, if Joe dies in 2025 with an estate valued at $15 million, then $99 million (the 2025 federal estate tax exemption amount) will go into the bypass trust, and $1.01 million will go into the marital trust. The assets in both trusts receive a basis adjustment (likely a step-up) as of Joe’s date of death.
- Joe’s trust provisions will specify whether and how Mary, his wife, receives income and principal from the bypass trust. Similarly, Joe can determine whether and how Mary can receive principal from the marital trust, although she is required to receive all income from the marital trust at least annually.
- When Mary dies in 2030, any property remaining in the marital trust will be included in her estate and receive a second basis adjustment (likely a second step-up) as of her date of death. However, property remaining in the bypass trust is not considered part of Mary’s estate and does not receive a second basis adjustment—it keeps the basis as of Joe’s date of death in 202 Because there is no basis adjustment at Mary’s death, the bypass trust potentially contains an income-tax time bomb.
How to Build Basis Planning into Your Estate Plan
There are several options to choose from if your goal is to maximize basis for your loved ones:
- Unwind the AB trust plan and instead leave everything outright to your surviving spouse so that the assets will receive a basis adjustment at your death—and again at your spouse’s death, assuming that the assets remain in their estate. The transfer from you to your spouse will likely qualify for the unlimited marital deduction, so your spouse will not owe estate tax at your death. However, it is important to remember that leaving everything to your surviving spouse outright means that the assets will be their property and may be susceptible to creditors, predators, judgments, or claims from a future spouse or partner.
- Keep the assets in the bypass trust and give the surviving spouse or other beneficiary a general power of appointment. The general power of appointment will cause the assets remaining in the bypass trust at the surviving spouse’s death to be included in their estate, thereby resulting in a second basis adjustment.
- For a wait-and-see approach to basis planning, allow for the appointment of a trust protector or trust advisor (if they are recognized within your state) in the trust’s terms and grant them the ability to add a general power of appointment to the bypass trust in favor of the surviving spouse. This will cause the assets in the bypass trust to be included in the surviving spouse’s estate at their death, thus resulting in a second basis adjustment.
Your circumstances will impact which option is the best fit. The great news is that there is almost always something that can be done to achieve your estate planning and asset protection goals that involves good basis planning.
Do You Need a Basis Planning Review?
Instead of falling back on the traditional one-size-fits-all AB trust plans, estate planners today must look carefully at each client’s unique family situation, financial position, and potential estate tax liability to determine the appropriate mix of techniques to minimize both estate taxes and income taxes. If it has been a while since you reviewed your estate plan, it may contain an income-tax time bomb. Call us with questions about basis planning and to arrange for a basis planning review.