In 2014, the federal estate tax exemption is $5.34 million for each spouse, and that exemption is portable (i.e., if not fully used by one spouse, the balance rolls over to the surviving spouse, if a Form 706 is properly filed).
However, most estate planners still recommend splitting assets between spouses because state estate taxes are not portable (i.e., if you don’t use it, you lose it). And the federal generation-skipping exemption (also $5.34 million) is not portable.
And so we arrive at a problem: There is only one step-up in cost basis at the death of the first spouse to die, not again at the death of the surviving spouse.
Most (if not all) state estate taxes are lower than the capital gain rate. For example, the Massachusetts estate tax rate (using the Credit for State Death Taxes) rises to 16 percent for the value of estates over $10,000,000. The highest federal capital gain rate is 23.8 percent (20 percent plus the Affordable Care Act (ACA) add-on of 3.8 percent at that level).
As a result, we are working with widows and widowers looking at moving the family trust (or bypass trust, or credit shelter trust) back into their taxable estate to get a second step-up in cost basis.
For example, here is a case I am working on right now:
The Mother died when the exemption was only $600,000. Her estate carved out that $600,000 into a family trust held for the benefit of her surviving husband and will then pass to their children upon his death. The cost basis of those assets stepped-up to $600,000 at her death. Today, her trust has grown to $1.5 million. If inherited by her children, upon the death of her husband, they could incur capital gains on $900,000. Using a 20 percent rate to cover state and federal capital gains, for example (could be higher or lower), they would pay $180,000 in income taxes (capital gains tax).
If her $1.5 million were added to her husband’s current $1.5 million estate, the heirs would have a full $3,000,000 of cost basis and not incur capital gains if they chose to sell the assets after their father’s death. If the surviving spouse now lives in a state with no estate tax, clearly that’s a winning strategy.
But, what if the husband lives in Massachusetts? An estate of $1.5 million would result in estate taxes of $64,400. An estate of $3 million would result in estate taxes of $182,000.
That’s about the same as the capital gain tax of $180,000. But, the family would have had to pay the $64,400 estate tax on father’s $1,500,000 of assets and the $180,000 capital gain on mother’s $1,500,000 of assets, if they chose to sell them.
This would yield a total tax of $244,400 instead of only the estate tax of $182,000. That’s a savings of $62,400.
Clearly, you need to look at the appreciated value over the cost basis versus the state estate tax to make the correct choice.
Income tax savings during lifetime
Consider another scenario: Parents who currently receive K-1 income from an S-Corp or LLC. They could gift some or all of their equity value (up to the $5.34 million exemption, each) into a properly drafted irrevocable trust without incurring federal tax.
Irrevocable trusts can be drafted so that income can be distributed to beneficiaries (though not equally to all beneficiaries). Income tax on assets held by the trust can be paid by: