Tax Law – Portability & the Double Basis Step-up

February 05, 2015

Article by C. Arthur Robinson, II

We are now in an environment where estate tax planning for income tax purposes is both a real possibility and a virtual necessity to create efficient estate plans from both a transfer tax and an income tax perspective.  There are several reasons why this is so and it is important to understand the opportunities available.

Several years ago, Congress put in place a $5 million lifetime exemption which applies in virtually all cases for U.S. taxpayers.  This exemption, which is indexed for inflation and is now $5.34 million as of 2014, was also made portable by changes to the statute.  That means the exemption amount unused by the first spouse to die could, under certain circumstances, be used by the second spouse.

It is important to realize that, as a result of assets passing from a decedent to either the surviving spouse or others, basis step-up takes place at the date of death.  This affords an opportunity to reset the basis in an advantageous way for income tax purposes.  It is possible, with our current environment, to do so twice; once on the first death and a second time on the death of the second spouse.

This is particularly noteworthy because when one combines federal and state income tax, in a great many places the income tax rates approach or exceed 50% of the taxable income.  Even for long term capital gains transactions, the effective rate of tax is essentially 30% or more, depending upon the state of residence.

As a consequence, all of these taxes have become much more important to plan for to minimize the potential tax exposure.  This is made doubly so by the fact that, for a married couple with an estate below $10.68 million, the effective rate for estate taxes is essentially zero, as the exemption knocks out what would otherwise be tax paid by the taxpayers.  Therefore, having assets flow through the estate of the first decedent and then flow through the estate of the second decedent of a married couple is very important.

There are a number of ways and means to accomplish this, and whether assets pass by operation of law, through a probate estate, or through some sort of trust instrument, it is wise to plan for the tax consequences.  In order to preserve the unused exemption for the first spouse to die, it is required that an estate tax return be filed for the first deceased spouse even if the taxable estate is vastly less than the exemption amount and no tax will be due.  This is the case because the assets which soak up a portion of the lifetime exemption, if any, have to valued and the Internal Revenue Service and the U.S. Treasury take the position that the only way to validly report those values is the preparation of an estate tax return on Form 706.

Whether assets should pass outright to the surviving spouse either through probate or by operation law or whether one or more types of trusts should be used is governed at this point by considerations that have less to do with estate taxes and far more to do with issues such as privacy, asset protection, probate avoidance and other non federal and state tax considerations.  We have both greater degrees of freedom and some opportunities which were previously unavailable, and so in virtually every case, it is smart to look at the plan for an individual as it currently stands, or make such a plan if one does not already exist, taking into account the potential for double-basis step-up for appreciated assets as well as other concerns, specifically with the non-tax issues recited above.

Planning for estates has gotten simpler in that we are more able to avoid tax for more of our clients, and more complex in that taking optimal advantage of the current environment requires careful analysis and planning.  We at Wolcott Rivers Gates can assist you in that regard.