Proper Planning For The Basis Of Assets Can Mean Significant Tax Savings

Planning: The client has a marketable stock she purchased for $14,000, which now has a value of only $10,000. If the stock is gifted to a child and the child sells it for $10,000, the $4,000 capital loss is effectively lost. Instead, have the client sell the asset for $10,000 and take a $4,000 capital loss. The $10,000 in cash proceeds could then be gifted to the child.

Most assets step-up to their fair market value at the time of the death of the decedent. However, if the asset was acquired by the decedent within one year of death and is bequeathed to the donor or a donor’s spouse, the deceased’s basis in the asset is not stepped-up to its fair market value. Instead, the beneficiary takes the decedent’s basis (IRC section 1014(e)). Thus, for example, if a client creates a joint tenancy with survivorship with their spouse (by transferring a one-half interest in property to the joint tenancy) and the donee/spouse then dies within one year, there is no step-up in basis even though one-half of the property is included in the deceased spouse’s estate. The purpose of this rule is to assure that taxpayers do not transfer assets to terminally ill family members to obtain a step-up in basis on those assets.

Planning: A client’s wife has a terminal condition and owns no assets. In 2004, the donor could transfer up to $1.5 million in low basis assets to the spouse, who revises her will to provide that those specific assets pass into a unified credit trust. If the wife dies within one year, the donor/spouse can disclaim his interest in the trust and the assets will step-up to their fair market value, saving taxes for the children. If the wife survives the transfer by one year, the step-up occurs and the disclaimer is unnecessary (i.e., the spouse can remain a beneficiary of the trust). In either case, the family saves up to $225,000 in capital gains taxes (i.e., $1.5 million times a 15% federal capital gains tax).

Planning: A number of years ago a wife created a brokerage account by placing $200,000 in the account. The account names both the wife and husband as owners. The account now has appreciated to $800,000 in value and the wife is seriously ill. If the wife dies, one-half of the account will be included in her estate (IRC section 2040(b)), with a resulting step-up in basis on only one-half of the account. If the husband has not drawn assets or income from the account, have him relinquish his interests in the account. Upon the wifes death, the entire account will step-up to its fair market value, potentially saving up to $45,000 in capital gain taxes (i.e., $400,000 minus the $100,000 basis (one-half) times a 15% federal capital gains tax). The bequest to the husband should not incur estate tax because of the unlimited marital deduction.

Divorce. Divorce negotiations should take into account the after-tax value of an asset, not its fair market value.

Planning: Assume a client has a choice between taking $1 million in cash or $1.1 million in stock which has a zero basis. Which is the better option? For tax purposes (assuming an immediate stock sale), the $1 million in cash is a better choice. Why? Assuming a combined state and federal capital gains rate of 20%, the $1.1 million is stock carries an inherent tax cost of roughly $220,000, meaning the asset has a true after-tax value of only $880,000.

The divorce decree should also require that the transferor spouse provide the transferee spouse sufficient records to support both the basis of the property and its holding period. Without such information, the IRS could challenge the client’s assertions and an ex-spouse may not cooperate by providing the needed information. Although Temporary Regulations 1.1041-1T, Q&A-14 requires that such information be provided at the time of any transfer, there are no penalties for not providing the information.

Redemption Agreements vs. Cross Purchases. There is a basis reason that corporate cross-purchase agreements are better than redemption agreements. If a corporation owns the insurance policy and an owner dies, the corporate redemption does not provide any income tax basis adjustment to the remaining owners. If the remaining owners own the policy on the deceased owner, they receive an increase in their income tax basis. For example, assume 3 equal owners intend to insure each of their lives for $5 million to fund a buy-sell agreement. Owner ‘A’ dies. If the corporation owns the insurance and carries out the redemption, the remaining shareholders receive no step-up in the tax basis in their stock. The surviving owners each own 50% of the business.

Planning: However, if the owners owned the insurance and used it to acquire the deceased shareholder’s shares, each owner would receive a $2.5 million increase in the income tax basis in their stockeven though they own exactly the same percentage of stock as they would have if the corporation had redeemed the stock. Assuming an effective state and federal capital gain tax rate of 20%, each shareholder could save up to $500,000 in capital gains taxes when they sold the stock. Unlike corporations, this limitation does not generally apply to LLCs and partnerships.

The basis in assets is often an ignored part of the planning process. Even with the current federal capital gain rate of 15%, properly planning for basis issues can provide significant tax savings to clients.

John J. Scroggin, J.D., LL.M., is an estate planning attorney in Roswell, Ga., and author of “The Family Incentive Trust,” published by The National Underwriter Company. He can be reached via e-mail at [email protected].

Reproduced from National Underwriter Edition, June 11, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.