Everyone has heard the old slogan about the inevitability of death and taxes. For 99.3% of the population death taxes will not be an issue for their heirs since an individual can transfer up to $5,250,000 or a couple up to $10,500,000 under the new American Taxpayer Relief Act of 2012 (“ATRA”). For the first time ATRA provides that the death tax exclusion amount is indexed for inflation so that it should increase significantly over time.
However, the income tax is still around and we all face having to pay our income taxes on an annual basis. One of the hot subjects currently being discussed in the new ATRA era is: How do you plan for a couple who will not be subject to the death tax but want to have as much of their assets be distributed to their heirs with a stepped up in basis on the survivor’s death to avoid income taxes?
Stepped Up Example. Let say a couple Bill and Jane owns stock worth $100,000 that was purchased for $10,000. If they sold the stock during their lifetime there would be a capital gain of $90,000. If Bill died first, Jane would be able to sell the $100,000 stock and pay no capital gain because both halves of their community property basis of $10,000 steps up to $100,000!!! The same would be true for real property or any other asset that appreciates in value. With rental real estate, Jane would be able to depreciate again the building on the rental property even though prior to Bill’s death the depreciation was completely used by both of them.
Portability. ATRA provides for a portability provision between spouses that allows the unused $5.250 million exclusion amount of the first spouse to die to be used by the surviving spouse on his or her death, for a total $10.5 million. Prior to 2011, in order for a married couple to assure this outcome, they used the A-B family trust on the death of the first spouse to transfer his or her assets into a nonmarital trust in order for it not to be taxed on the surviving spouse’s death.
Portability Advantage Example. Bill leaves his wife Jane $3 million in a bypass trust and Jane outlives him 10 years. Over that time the income is spent but the fair market value has doubled to $6 million. Jane has her own $3 million in assets. At Jane’s death, their children inherit assets in the bypass trust with only $3.5 million in basis (assuming net $500,000 realized gains over depreciation or realized losses). Had Bill left his assets (i) to her outright or (ii) to a differently designed trust and Jane elected to use her Deceased Spousal Unused Exclusion Amount (DSUEA) (Bill’s remaining unused $2,250,000 million that is added to Jane’s $5,250,000 for a total of $8 million) heirs would receive a new step up in basis to $6 million, potentially saving them $750,000 or more!
Portability Disadvantages. Portability is great where there has been no estate planning by failing to create an A-B family trust in the example above in order to avoid death taxes on Jane’s death. However, if (i) Jane remarried and gave Bill’s $3 million to someone other than to his children or (ii) had creditor problems and the $3 million was not protected by a spendthrift provision in Bill’s bypass trust then portability would be a very poor choice.
Another major disadvantage based upon the above example is that Bill’s DSUEA of $2,250,000 is fixed and does not get benefit for the index for inflation. Bill’s bypass trust can grow to any amount and not be subject to death taxes.
Proper Step Up Planning. The solution to avoid all of the disadvantages of portability and also have Jane’s heir receive the $750,000 new basis is to have a properly designed bypass trust that give Jane the ability to make certain elections over Bill’s assets prior to Jane’s death. Another solution is the use of a martial trust to get to the same result.
In the future it is possible to have the best of all worlds for a step up in basis for appreciating assets (not IRA or qualified plans) on the death of both spouses. It is merely how your family trust is designed based upon the nature of your assets and size of your estate.