Important Tax Considerations in Estate Planning
In years past, if a client sought counsel for estate planning, one of the first topics of discussion
would have been crafting an estate plan to avoid estate taxes. Historically, federal estate tax
exemptions have been low and estate tax rates have been very high, so it made sense to focus
on estate taxes as an important part of the planning process. Today, however, federal estate tax
exemptions have risen substantially and many states have either raised their estate tax
exemptions considerably or eliminated them altogether. For 2023, the federal estate tax
exemption is $12.92 million per taxpayer (or $25.84 million for a married couple), so for many
clients, estate tax concerns have given way to other worries.
While estate tax planning is not as relevant today as it once was, estate planning is an essential
factor in minimizing income tax burdens for clients, their families, and their businesses. To truly
understand how estate planning can help clients with other tax concerns, clients must first
understand some basic tax concepts, such as income tax basis, carryover basis, and step-up
basis or basis adjustments. It is also important to discuss with your clients how income taxation
issues can impact their estate plans.
Basis
Income tax basis refers to the amount of a client's capital investment in property for income tax
purposes. In other words, the basis of an account or piece of property is typically how much it
cost your client (the purchase price). Basis can also take into account additional investments in
a piece of property and indebtedness. If the account or property is a gift or inheritance, other
rules apply and the basis of that account or property may be adjusted.
Carryover basis is the term applied to the value of accounts and property passed from one
person to another as a gift, such as stocks or property. The basis of the accounts or property
remains the same as when the giver held that account or property - the basis is carried over to
the gift recipient.
When accounts and property are inherited from a person who passes away, the accounts and
property are treated as if the decedent sold them for value at their death and this is referred to
as a basis adjustment. The basis is the fair market value of the account or property on the
decedent's date of death and it is transferred to the beneficiary. If the value of the account or
property has increased since the decedent first acquired it, there would be a step-up in basis. If
the value has decreased since the decedent first acquired it, there could be a step-down in
basis. In the event of a step-up in basis, a beneficiary may be able to avoid or minimize the
capital gains due when selling the account or property at a later date.
If your client has low basis accounts and property (meaning that the accounts and property have
significantly appreciated since their original purchase or acquisition date), planning for the
transfer of such accounts and property during the client's lifetime or at the client's death is an
important and often overlooked tax-saving strategy. For example, for a married couple with wills
leaving everything outright to each other, a full step-up basis for their accounts and property at
the death of the surviving spouse is easy to achieve. However, many married couples have
estate plans that include multiple trusts and, depending on how the trusts are structured, tax
issues can be complicated. Creating a marital trust (also referred to as an "A trust") and a
bypass or family trust (also known as a "B trust") has been the preferred method for those
clients who are likely to be subject to estate tax. Under this trust structure, upon the death of the
first spouse, accounts and property transferred into the A trust for the surviving spouse's benefit
are exempt from estate tax at the time of the first spouse's death due to the unlimited marital
deduction for property passing to surviving spouses and receive a basis adjustment. When the
second spouse passes away, the accounts and property in the A trust receive an additional
basis adjustment because these accounts and property are included in that spouse's taxable
estate. However, the accounts and property in the B trust do not benefit from a second basis
adjustment at the second spouse's death. Depending on the account and property values in the
B trust, there can be significant tax implications in this arrangement.
So, if your clients own low-basis accounts and property, it would be wise to review how the
carryover or basis adjustment of those accounts and property may impact your clients and their
beneficiaries.
Income Tax
During the pandemic, many clients felt compelled to initiate estate plans. Many of those estate
plans included the use of trusts and it is important that your clients understand who pays income
taxes on trust's accounts and property.
If a trust is a grantor trust (meaning the person who makes the trust, the grantor, is also the
person in control of the trust), the grantor pays all taxes related to the trust during their lifetime
and the trust income is included on the grantor's personal income tax return. Any taxes owed
are paid at the grantor's individual income tax rate.
If a trust is a nongrantor trust (any trust that is not a grantor trust is considered a nongrantor
trust because the person establishing the trust has no rights, interests, or powers over the
trust's accounts and property), either the trust pays the income tax, or, if income is distributed to
a trust beneficiary, that beneficiary pays tax on any trust income received at the beneficiary's
individual income tax rate.
Because trusts reach the highest marginal income tax rate at a much faster pace than
individuals (due to compressed tax brackets for trusts), when you advise your clients about the
income tax planning opportunities that exist for using grantor and nongrantor trusts, it is
important to caution them about the potential tax pitfalls of each trust type. By way of example,
the highest marginal income tax rate for both individuals and trusts is currently 37 percent.
However, an individual reaches the 37 percent bracket only when that individual's taxable
income exceeds roughly $523,600 ($628,300 if married and filing jointly), while a trust, on the
other hand, reaches that same 37 percent bracket on taxable income of just over $13,451. This
means that trusts may be subject to a higher tax rate on the same amount of income than an
individual in a similar tax bracket.
When a nongrantor trust makes a distribution to a beneficiary, the income is passed out to the
beneficiary and taxed on their personal income tax return. The distribution is captured on
Schedule K-1 of Form 1041, and the trust then takes a distribution deduction for income tax
purposes.
Absent creditor protection concerns, if a beneficiary is in a lower tax bracket than the trust - and
most beneficiaries are - it will make sense for the trust to distribute all or part of the income to
the beneficiary so that the distributed income can be taxed at a lower rate than it would be taxed
at if it had been paid by the trust.
Estate planning is an important process for minimizing taxes associated with transferring
accounts and property. Helping your clients understand the role of income tax basis, carryover
basis, and step-up basis or basis adjustments, along with the income tax implications of using
different types of trusts in estate plans is necessary in order to maximize the efficiency of
crafting an estate planning for your clients.
MEREDITH | PC
4325 Windsor Centre Trail
Suite 400
Flower Mound Texas 75028
214-513-1013
This newsletter is for informational purposes only and is not intended to be construed as written advice about a Federal tax matter. Readers should consult with their own professional advisors to evaluate or pursue tax, accounting, financial, or legal planning strategies.
You have received this newsletter because I believe you will find its content valuable. Please feel free to Contact Me if you have any questions about this or any matters relating to estate planning.
