Importance of Income Tax Planning as Part of your Estate Plan

As a result of the large estate tax exemption amount that was set in 2011 at $5 million (increased to $10 million for estates of decedent's dying in 2018 through 2025), which increases annually for inflation (the amount is $11,180,000 in 2018), many modest estates no longer need to be concerned with federal estate tax. Before 2011, the smaller estate tax exemption amount resulted in estate plans that attempted to avoid the estate tax, but were not concerned with minimizing income tax. Now, because many estates will not be subject to estate tax (thanks to that large exemption amount), planning for such estates can be devoted almost exclusively to saving income taxes. While saving both income and transfer taxes has always been a goal of estate planning, it was more difficult to succeed at both when the estate and gift tax exemption level was much lower. Below are some tax planning strategies you may want to revisit in light of the large exemption amount and other recent changes in the law.

Gifts that use the annual gift tax exclusion. One of the benefits of using the gift tax annual exclusion to make transfers during life is to save estate tax. This is because both the transferred assets and any post-transfer appreciation generated by those assets are removed from the donor's estate. However, because the estate tax exemption amount is so large, estate tax savings may no longer be an issue. Further, making an annual exclusion transfer of appreciated property carries a potential income tax cost because the donee receives the donor's basis upon transfer. Thus, the donee could face an income tax cost, via a capital gains tax liability, on the possible sale of the gifted property in the future. If there is no concern that an estate will be subject to estate tax, even if the gifted property grows in value, then the decision to make a gift should be based on factors other than estate tax savings. For example, gifts may be made to help a family member with making a purchase or starting a business. But a donor should not gift appreciated property because of the capital gain that could be realized on a future sale of the property by the donee. If the appreciated property is held until the donor's death, the heir will get a step-up in basis that will wipe out the capital gain tax on any pre-death appreciation in the value of the property.

Planning that equalizes spouses' estates. In the past, spouses often undertook complicated strategies to equalize their estates so that each could take advantage of the estate tax exemption amount. Generally, a two-trust (a credit shelter trust and marital trust) plan was established to minimize estate tax. "Portability," or the ability to apply the decedent's unused exclusion amount to the surviving spouse's transfers during life and at death, became effective for estates of decedents dying after 2010. As long as the election is made, portability allows the surviving spouse to apply the unused portion of a decedent's applicable exclusion amount (the deceased spousal unused exclusion (DSUE) amount) as calculated in the year of the decedent's death. So, if a spouse dies in 2017, when the estate tax exclusion amount is $5,490,000, without having used any exclusion amount over the course of the deceased spouse's life, the surviving spouse would be able to apply the DSUE amount of $5,490,000 to any taxable transfers made. If the surviving spouse were to die later in 2017, then the surviving spouse will be able to use an exclusion amount of $10,980,000 (both the DSUE and the surviving spouse's exclusion amount). In this example, if the surviving spouse dies in a later year, the DSUE amount remains fixed at $5,490,000, but the surviving spouse's basic estate exclusion amount will increase annually. The portability election gives married couples more flexibility in deciding how to use their exclusion amounts.

Estate exclusion or valuation discounts that do not preserve the step-up in basis. Some strategies to avoid inclusion of property in the estate may no longer be worth pursuing. It may be better to have the property be included in the estate or not qualify for valuation discounts so that the property receives a step-up in basis. For example, the special use valuation - the valuation of qualified real property used for farming purposes or in a trade or business on the basis of the property's actual use, rather than on its highest and best use - may not save enough, or any, estate tax to justify giving up the step-up in basis that would otherwise occur for the property if the special use valuation is not applied. Also, estates where property was transferred to avoid estate inclusion by limiting the transferor's power or control over the property may now welcome that inclusion because that inclusion would mean a step-up in basis, saving potential future capital gain tax. The gap between the transfer tax rate and the capital gains tax rate has narrowed, making strategies that do not preserve the step-up in basis less desirable.

Keep in mind that the increase in the estate tax exemption is only temporary as of right now, effective for 2018-2025. There are many factors to consider when determining what steps to take when estate planning.

If you would like to discuss these strategies, and see how they may relate to your estate plan, please contact us.