When a client (or a client’s family member) is facing a shortened life expectancy, personal well-being, medical decisions and family matters quite rightly take priority over financial concerns. That said, when consistent with the client’s goals and wishes, there may be income tax planning strategies worth considering to help avoid unnecessary tax burdens. This article primarily focuses on planning strategies related to the management of income tax basis.
At death, assets includible in a decedent’s estate (other than certain assets such as retirement plan benefits) receive a new income tax basis equal to their fair market value at death. This means that those assets receive a “step-up” in basis if the fair market value is greater than the current basis or may receive a “step-down” in basis if the fair market value is less than the current basis.
Attaining a Step-Up in Basis
Assets that receive a step-up in basis avoid being subject to capital gains tax on the appreciation that occurred from the time of purchase to the date of death. Therefore, it can be beneficial to hold low-basis assets until death to avoid capital gains on that appreciation.
A client who has low-basis assets may wish to gift those assets to an individual (such as the client’s parent) with a shortened life expectancy and then have that individual donee at death leave the assets back to the client with a new stepped-up basis. This type of planning is generally viable only where the gift to the donee will not cause the donee’s estate to be subject to estate tax (i.e., because the individual’s taxable estate is below the applicable estate tax exemption amount). Congress has placed important limits on this strategy. In particular, the tax law denies a step-up in basis for appreciated property that is gifted to a person within one year of that person’s death if the property then returns to the donor (or the donor’s spouse). As a result, a basis adjustment is available only if the recipient survives for at least one year after receiving the property. However, the donee may leave the property to certain types of trusts for the benefit of the donor since that trust would not be considered the same as leaving the property to the donor.
Another technique involves the client creating an irrevocable trust and making a gift of low-basis assets to the trust (using gift/estate tax exemption) and granting a general power of appointment over the trust assets to an individual with a shortened life expectancy (such as a parent). A general power of appointment gives an individual the power to direct how the assets pass at their death, and if the power is not exercised, then the assets pass as provided under the trust document. Those assets will be included in the estate of the holder of the general power of appointment and will receive a step-up in basis at death. Although there is always the risk that the individual will actually exercise the power and leave the assets to someone not intended by the client, the client would likely only give this power to a trusted and close family member.
Avoiding a Step-Down in Basis
If the market value of an asset has declined below its original purchase price, the asset’s income tax basis will step down at death to its lower fair market value. This means that the estate will not be able to get a capital loss when the asset is sold. However, if the client sells the asset prior to death, then the client would be able to offset capital gains incurred in the same tax year with the capital loss. Remaining losses can be carried forward but not after the death of the taxpayer. Alternatively, the client may gift depreciated assets before death since the donee will take the donor’s basis (this is known as “carryover basis”).
Utilizing a “Swap” Power
For clients who have previously established certain types of trusts known as “grantor trusts” (i.e., a trust drafted with certain provisions so that the grantor of the trust is considered the owner for income tax purposes), there may be opportunities to reposition assets to achieve more favorable tax results, assuming that the grantor has adequate cash or high-basis assets. Often, these trusts will include a substitution power that gives the grantor the right to “swap” assets of equivalent value held by the trust without triggering income tax. However, even without the swap power included in the trust, if the trust is a grantor trust, then the trustee may choose to sell assets to the grantor of the trust without any income tax consequences. This exchange will result in low-basis assets being included in the client’s estate and receiving a step-up in basis at death.
Otherwise, if the low-basis assets remained in the trust, they would not receive a step-up in basis, assuming the trust assets are not included in the grantor’s estate. Similarly, a client with assets that have a basis greater than their current fair market value may transfer those assets to the grantor trust in exchange for other assets of the same value, allowing those assets transferred to the trust to avoid a step-down in basis at death. In this context, the one-year look-back rule described above does not apply because this transfer of assets is not a gift.
Conclusion
Income tax basis planning near the end of life is a nuanced and highly technical area that must be approached with care. While these strategies are not appropriate in every situation, thoughtful tax basis planning may help reduce unnecessary capital gains taxes and preserve more wealth for intended beneficiaries. Professional guidance is essential to ensure that any such strategies are implemented properly and without unintended tax consequences. For more information, please contact Hannah E. Ellis (hellis@brodywilk.com) or another BW attorney.
