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

The basis of assets is often an overlooked part of the planning process. This article will highlight a number of areas that can provide significant benefits to clients who address the issue.

Step-Up in Basis. Effective Jan. 1, 2004, the estate tax unified credit exemption amount jumped to $1.5 million per individual. Effectively, a married couple can pass $3 million tax free. Note that the gift tax unified credit exemption amount remains $1 million and does not change in the coming years.

As a result of these higher exemption amounts, it has been estimated that over 98% of Americans will not be subject to a federal estate tax liability, assuming they do basic planning.

Planning: With the vast majority of estates being non-taxable, tax planning is going to shift from a focus on estate tax avoidance to a focus on income tax avoidance. For example, with the unified credit being $1.5 million (or $3 million for a married couple) in 2004 and a step-up in basis to a fair market value being provided at the time of the death of either spouse (IRC section 1014), we may see a reversal in asset valuation.

For years much of our fighting with the Internal Revenue Service has been to deny its argument that the estate was worth more than the client indicated, resulting in a higher estate tax. With the higher exemptions planners may actually want to drive up the value of the estate assets in order to get a higher step-up in basis and thereby reduce the future ordinary income (e.g., depreciation of depreciable assets) or capital gains (e.g., upon the sale of the asset).

Lifetime Basis Issues. But basis issues also exist during the life of the client. Many advisors are unaware of the unique basis issues which apply to gifts. In general, the donee of an asset takes over the tax basis of the donor. IRC section 1015(a) provides: If the property was acquired by gift…, the basis shall be the same as it would be in the hands of the donor … except that if such basis … is greater than the fair market value of the property at the time of the gift, then for the purpose of determining loss the basis shall be such fair market value.

The result of this rule is that the donors appreciation on the gifted asset normally will be taxed to the donee.

Planning: If a low basis asset is transferred to the donee, the value of the gift is effectively reduced by the income tax or capital gains tax the donee will ultimately pay upon the sale of the asset. For example, if a zero basis stock worth $10,000 is transferred to a child, the real value of the gift may only be $8,500 (i.e., $10,000 less a 15% federal capital gains tax). Instead, consider selling the asset and gifting cash of $10,000 to the child. Not only is a higher value transferred out of the estate, but the payment of the capital gains tax effectively reduces the donors estate.

Planning: One of the concerns with lifetime gifting using the unified credit has been the presence of low basis assets, with the donee having to use the donors basis rather than a date-of-death step-up to fair market value. With the unified credit increasing and the capital gains tax dropping, lifetime gifting using the unified credit may become an even more significant tax savings tool, even with low basis assets. For example, assume in 2006 a client funds a lifetime unified credit trust with zero basis assets worth $1 million that are growing at 12% per year. If the client is in a 45% estate tax bracket (i.e., the applicable rate in 2007), the 15% federal capital gains cost is recovered by the savings in estate taxes in about 3 years.

If the donor’s basis in the asset exceeds its fair market value, the rules get a little more complicated for the donee. If the donee subsequently sells the asset for a gain, the donee uses the donor’s basis in the property (Treasury Regulation section 1.1015-1(a)(1)). If the donee sells the asset for a loss, the fair market value of the donated assets is used as the basis. Thus, if the donee sells for a price between the fair market value and the donor’s basis, neither a loss nor a gain is incurred (Treasury Regulation section 1.1015-1(a)(2)). Unlike a gift, the basis of an asset transferred at death is the asset’s fair market value, even if the fair market value is lower than the asset’s date-of-death basis.

Planning: A terminally ill married client has a currently unmarketable asset which has reduced substantially in value (e.g., the basis is $500,000 and the value is $200,000). If the client dies, the assets basis will step-down to its fair market value, resulting in the family losing the tax benefit of the inherent loss in the asset. Instead, have the terminally ill client gift the asset to his spouse. If the spouse subsequently sells the asset for a value from $200,000 to $500,000, no taxable gain will be reported on the sale.

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 jeff@scrogginlaw.com.


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.