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How planning can minimize the impact of income taxes

Posted On: JANUARY 2024

Until recently, estate planning strategies generally focused on removing as much wealth as possible from one’s estate to avoid the bite of federal estate tax. Although there were income tax advantages to retaining assets in an estate, the estate tax costs usually eclipsed any potential income tax savings.

But things have changed: Between 2001 and 2023, the federal gift and estate tax exemption soared from $675,000 to $12.92 million. During that same time, the highest estate tax rate dropped from 55% to 40%. (Note: In 2026, the exemption is scheduled to drop to around $6 million, barring further legislation from Congress.) Today, only the wealthiest of families are exposed to estate tax liability, elevating the importance of income tax planning.

Income vs. estate tax

Here’s why income tax matters: If you give an asset to your child or other loved one during your lifetime, your tax basis in the asset carries over to the recipient. If the asset has appreciated significantly in value, that means a sale of the asset will result in a capital gain.

For example, say you bought a piece of real estate 20 years ago for $200,000 and its value has grown to $1 million. If you give the property to your child, who decides to sell it, he or she will be liable for as much as $160,000 in long-term capital gains tax (20% of the $800,000 gain).

In contrast, when an asset is transferred at death — that is, via “bequest, devise or inheritance” — the recipient’s basis is “stepped-up” to the asset’s date-of-death fair market value. The recipient can turn around and sell the asset tax-free (apart from any tax on post-death gains). Thus, from purely an income tax perspective, it’s advantageous to hold on to appreciating assets rather than gifting them during your lifetime.

If there’s little chance that your estate will exceed the gift and estate tax exemption, then retaining these assets until death can minimize the impact of income tax on your heirs. However, if your estate is large enough that estate tax liability is a concern, the possibility of income tax savings may be outweighed by the potential estate tax bill. In that case, a better strategy may be to remove assets from your estate — through outright gifts, irrevocable trusts or other vehicles. Doing so will shield future appreciation in their value from estate tax.

Crunch the numbers

To determine the right strategy for you and your family, you need to do some forecasting. By estimating the potential income and estate tax liabilities associated with various options, you can get an idea of whether you should focus your planning efforts on income tax or estate tax. Of course, if there’s little chance that your estate will exceed the exemption (even if it falls in 2026), then it makes sense to adopt strategies that minimize income tax. But for some families, it may be a closer call.

Suppose, for example, that Mark (a single father) owns assets valued at $7 million, including a piece of real estate valued at $1 million with a $200,000 tax basis. If he gives the property to his daughter, Ella, she’ll be exposed to $160,000 in income tax if she sells it (assuming she’s subject to the 20% long-term capital gains rate). The gift is free of gift tax by virtue of the $12.92 million exemption.

Now, suppose instead that Mark holds on to the property until his death in 2026. At that time, the real estate value has grown to $1.2 million, Mark’s taxable estate is $7.5 million, and the estate tax exemption has dropped to $6 million. Ella inherits the real estate with a stepped-up basis of $1.2 million, avoiding $200,000 in capital gains tax. But Mark’s estate is subject to $600,000 in estate taxes [40% x ($7.5 million – $6 million)]. Had Mark given Ella the property earlier, she would be potentially liable for $160,000 in income tax but Mark’s estate would have been reduced by $1.2 million to $6.3 million, resulting in estate taxes of $120,000 — a $480,000 savings.

Peer into your crystal ball

As the above example shows, unless it’s clear that estate tax won’t be a concern, determining the right strategy requires some prognosticating. The answer depends on several factors, many of which are uncertain, including how long you’ll live, whether (and how much) your assets will appreciate and whether estate tax rates or exemption amounts will be adjusted further by Congress. We can help you navigate these uncertainties and design a plan that makes sense for you.

Sidebar: IRS: No stepped-up basis for assets in grantor trust

The intentionally defective grantor trust (IDGT) is a popular estate planning tool that allows you to remove assets from your estate for estate tax purposes while continuing to be treated as their owner for income tax purposes. A type of irrevocable trust, an IDGT allows you to shield all future appreciation in the assets’ value from estate tax, while continuing to pay the trust’s income taxes, further reducing the size of your taxable estate.

Some experts have argued that because assets gifted to an IDGT remain taxable to the grantor for income tax purposes, they’re entitled to a stepped-up basis in the hands of the beneficiaries. However, in Revenue Ruling 2023-2, the IRS clarified that assets in an IDGT aren’t received by bequest, devise or inheritance and, therefore, aren’t eligible for a stepped-up basis.

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