Planning for the New Death Tax

“It’s not the strongest of the species that survives, nor the most intelligent that survives. It is the one that is the most adaptable to change” – Charles Darwin

Formula estate tax clauses in trusts have long been a staple planning strategy to protect families from the estate tax. With recent tax law changes, these formula clauses may now be a liability and may trigger higher taxes. As recently as 2001, the estate tax exemption was $675,000 and the highest estate tax rate was 55%. Upon the death of the first spouse to die, if the deceased spouse’s exemption was not used it was lost forever. All wealth passed to the surviving spouse and only $675,000 could be protected from the estate tax at the surviving spouse’s death. A married couple could use both exemptions to shelter $1,350,000 from estate taxes, but only if they implemented an A-B Trust tax strategy in their Will or Trust. With changes in the tax system, that strategy may trigger substantially higher capital gains taxes.

The estate tax exemption has increased to $5.45 million today, resulting in less than 0.2% of the U.S. population now being subject to the estate tax. The estate tax rate is now a flat 40%. In addition, Congress now allows the executor of a decedent’s estate the option of transferring the deceased spouse’s unused exemption amount to a surviving spouse rather than funding a bypass trust using the A-B Trust strategy. This is known as “portability.” With the changes in the estate tax and higher income tax rates, such as the introduction of the Net Investment Income (NII) tax, the focus of estate planning has shifted to income tax basis planning.

Income tax basis is usually the cost to buy an asset. When an asset is sold, income taxes in the form of capital gains are calculated by subtracting the basis from the sales price. For example, if you buy $10,000 worth of Apple stock and sell the stock when it is worth $15,000, you will owe capital gains tax on the $5,000 gain. If you gift the stock during life to another person, they receive your basis in the stock and will incur the same gain if the stock is sold. This is referred to as “carry-over basis.”

When property is transferred at death, the income tax basis is adjusted to equal the market value at the date of death. This is referred to as a “step-up” in basis. In the example above, if you die owning $15,000 worth of Apple stock, the tax basis in the hands of the inheritor is $15,000. If the stock is immediately sold, there are no capital gain taxes.

Including assets in the deceased person’s estate is the key to receiving a “stepped-up” income tax basis. With the traditional A-B Trust plan, property is intentionally excluded from the surviving spouse’s estate. For example, Tom dies with $6 million and is survived by Linda. His estate plan directs $5.45 million of property to Trust A, with the balance of $550,000 going to the marital trust, or Trust B. The assets in both trust shares receive a stepped-up basis as of Tom’s date of death. However, the property in Trust A does not receive a step-up in income tax basis upon Linda’s subsequent death. If Linda lives several years and the property in Trust A appreciates in value, their children will receive the property in Trust A without a second step-up in basis at Linda’s death, resulting in capital gains tax upon the sale of an asset.

Under the new tax landscape, it is critical to move away from the old formula based plan, to a more flexible plan that utilizes the marital deduction (formerly Trust B) and portability. The additional basis step-up in the surviving spouse’s estate is a clear advantage for couples whose combined net worth is expected to be less than twice the estate tax exemption amount. For couples whose combined net worth is more than double the estate tax exemption amount, the estate tax savings achieved by funding the bypass trust (commonly referred to as Trust A) after the first death may outweigh the loss of the step-up in basis. Today, we recommend a planning strategy which allows your estate to adopt the most tax-efficient trust design at the time of your death, taking into account both estate and income taxes.

The conventional A-B estate planning strategy that maximized the use of the estate tax exemption may now create a negative tax result. A more flexible design that takes advantage of the new portability rules and the marital deduction is now recommended for the best tax result. Please review your existing plan to see if the A-B Trust (Family Trust – Marital Trust) design is used in your estate plan. If it is, please contact Dan C. Peare or Hugh W. Gill to see if a modified plan design is recommended.