What Assets Are Important to Me and My Family?

One of the most important things that you should focus on when you meet with your accountant or CPA this tax season is to review which assets now and in the future will be the most important to both you and your family.  Recently, I attended the USC Tax Institute and a nationally known speaker pointed out how our traditional thinking for tax planning has now change to focus almost exclusively on the income tax rather than death taxes.

The speaker used a very simple example to illustrate his point when he discussed the traditional IRA and its impact today compared to just two years ago.  Traditional IRA’s assets do not get a step up in basis compared to other assets listed below on your.  This mean the old planning of just withdrawing the annual minimum amount leaves your spouse or children with ordinary income liabilities.  It makes sense to withdraw more from the IRA and not use up your other assets that can get a step up.

Everyone has heard the old slogan about the inevitability of death and taxes.  Currently, for 99.7% of the population death taxes will not be an issue for their heirs since an individual can transfer up to $5,490,000 or a couple up to $10,980,000 under the new American Taxpayer Relief Act of 2012 (“ATRA”). We must wait to see what Congress does in 2017 regarding if the estate tax will be repeal and if so, for how long.

However, the income tax is still around and we all face having to pay our income taxes on an annual basis. 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?

Step 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.

Rating of Assets for Step Up. If one were to list asset categories or types, starting with those that benefit the most from the “step-up” in basis and ending with those that benefit the least (or actually suffer a “stepdown” in basis), it might look as follows:

(1)       Creator-owned intellectual property (copyrights, patents, and trademarks), intangible assets, and artwork;

(2)       “Negative basis” commercial real property limited partnership interests;

(3)       Investor/collector-owned artwork, gold, and other collectibles;

(4)       Low basis stock or other capital asset;

(5)       Roth IRA assets;

(6)       High basis stock;

(7)       Cash;

(8)       Stock or other capital asset that is at a loss;

(9)       Variable annuities; and

(10)      Traditional IRA and qualified plan assets.

Family Business.  For individuals or families that operate their businesses either as Limited Liability Companies (“LLC”) or Limited Partnerships (“LP”), the advantage is to receive a stepped up in basis in the LLC’s or LP’s assets on the death of the owner compared to either a C or S Corp.  For C or S Corp only the shares of stock receive a step up in basis and not the C or S Corp assets.

Most LP and LLC operating agreements provide that a retiring or deceased owner will be paid fair market value for his, her, or its interest. “Fair market value” reflects applicable discounts for lack of marketability and, where appropriate, being a minority interest. This means if discounts were required to be utilized by the IRS the underlying assets would not receive a full stepped up in basis.  For example, an asset that has a $0 basis that is worth $100,000 and subject to a discount of 30% would valued at $70,000.  If it were sold there would be a $30,000 gain.

But an LLC or LP agreement could be amended to provide that withdrawing or deceased owners are entitled to liquidation value (net asset value) instead of fair market value. That increases the fair market value of the ownership interests. To the extent that this change affects all owners, there should be no income or gift tax consequences to the amendment.  What this means in the above example is that there would be no $30,000 gain if the asset were sold.

Another option to eliminate discounting on a LP or LLC interest is to transfer those interests to a General Partnership in exchange for a general partnership interest. This causes the general partnership in to be valued at the liquidation value and not the fair market value under state law.

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