The Importance of Basis… the new era of estate planning

10/01/15 | WealthCounsel Quarterly | Jeremiah H. Barlow, JD

Understanding basis and how it applies in estate planning is one of the foundational concepts of the post-ATRA era. Prior to the enactment of the American Taxpayer Relief Act (ATRA) in 2013, the primary goal in estate planning was to leverage transfers in order to reduce the size of the estate upon death, and minimize the effects of estate tax. This included using bypass trusts or other similar mechanisms to reserve a deceased spouse’s unused estate tax exemption. This strategy was sound, as the aggregated federal and state transfer taxes were much greater than income tax rates.

In stark contrast, today’s post-ATRA environment is one with increased income tax rates, and significantly higher federal transfer tax exemptions. This change represents a significant paradigm shift towards minimizing income tax. Due to this new tax landscape, the focus of estate planning has moved to income tax-centric strategies, most notably, leveraging the step-up in basis.

After providing a foundational understanding of basis, this article then outlines some key reasons why it is most beneficial to retain assets in a deceased individual’s estate to gain a step-up in basis for the inherited assets, and reduce income tax upon the sale of those assets.

What is Basis?

In its simplest form, basis is the cost to purchase the asset.[i] For example, if you purchase stock, your basis is the purchase price, plus costs and transfer fees. Basis is important because upon the sale of an asset, capital gains tax liability is calculated based on the increase from the sale price and the basis. (Conversely, capital losses arise when the asset is sold for an amount less than its basis.)

In estate planning, perhaps more important than basis itself, is how it is treated upon transfer. The two important transfer of basis rules are 1) transfer of basis upon death (or “step-up” basis) and 2) transfer of basis during life (or “carry-over” basis).[ii]

Here is a quick primer on how these two rules work:

Step-up Basis: Pursuant to IRC §1014, property that transfers at death is stepped up to the fair market value of the property on the date of death. By way of example, if a stock was originally purchased by a decedent for $5, and upon the decedent’s death the stock is now worth $100, the basis is stepped up to $100. The result is that the recipient of that stock can now liquidate that stock at $100 with no capital gains tax liability.

Carry-over Basis: Under IRC §1015, if property is gifted from a donor to a donee, then the donee inherits the basis of the donor. For example, if stock that was purchased for $5 is gifted, then the donee’s basis is the same as the donor’s. In this case, five dollars.

Importantly, a step-up in basis can only be achieved for assets that are in the gross estate of the decedent.[iii]

Flexibility is King

In today’s high income tax environment, taking advantage of a step-up in basis at death can be advantageous. In the past, we would create estate plans instructing that upon a surviving spouse’s later death, the assets would be distributed into a Survivor’s Trust and a Bypass Trust (and possibly a QTIP). Many trusts distributed the assets into these various trusts based on formulas that compared a couple’s estate value to the estate tax at the time of death. The result was more-or-less a blind distribution of assets into these trusts, without regard to the character of the asset or its basis.

Gone are the days of merely designing an estate plan to blindly funnel assets into a bypass trust upon a first spouse’s death, especially if there is no estate tax exposure.[iv] The assets placed in a bypass trust are not included in a surviving spouse’s estate and thus do not receive a step-up in basis once the surviving spouse dies. This can create a negative income tax effect if assets in the bypass trust substantially appreciated while in the trust, and the beneficiaries later wish to sell the appreciated assets upon the surviving spouse’s death. In short, the beneficiaries are stuck with carry-over basis of sorts. Basis would be adjusted when the first spouse dies, but would not be adjusted again when the survivor died because the assets “bypassed” that survivor’s estate.

Today, estate plans should be drafted to maximize flexibility to take advantage of the step-up in basis at a client’s death. Here are a couple options and considerations when planning for basis flexibility.

Leveraging General Powers of Appointment to Maximize Basis

When used correctly, powers of appointment can be a strong tool for basis management.[v] Carefully crafted powers of appointment can lend flexibility by allowing inclusion in the gross estate, and subsequently result in a step-up in basis.

Granting an individual a general power of appointment is a frequently-used method to force estate tax inclusion without granting actual possession. Merely holding the power creates estate tax inclusion, regardless of whether it is acted upon. For example, if an individual exercises a testamentary general power of appointment, property subject to the power is considered to have passed from the decedent holding the power, and thus, the property will receive a step-up in basis for income tax purposes. Similarly, if an individual dies without exercising a testamentary general power of appointment, the property will also receive a step-up in basis because it is considered to have been acquired by the deceased power holder.[vi]

Another option planners can leverage is a formula-based testamentary power of appointment. Drafting powers with a formula that absorbs the remainder of a beneficiary’s unused exclusion amount provides a step-up in basis to assets under the power, while sidestepping federal estate tax liability.

There are some issues to be aware of when using a general power of appointment. First, is how broad or narrow to draft the power of appointment. Powers of appointment are beneficial to the extent that the income tax saved by increasing tax basis exceeds the estate tax inclusion cost. Factors to consider in the tax formula: 1) ratio of the federal estate tax attributable to the general power of appointment, to the anticipated income tax savings if the property was included in the gross estate; 2) income tax rates (federal and state) at the time of sale; 3) depreciation rate in light of the trust’s depreciable property; and 4) assets receiving greatest benefit from the built-in gain.

Although beyond the scope of this article, there are additional drafting options to increase flexibility, such as utilizing a trust protector/advisor (to later trigger a general power of appointment), decanting (when an existing irrevocable trust does not have flexibility), as well as merely distributing the assets outright to a surviving spouse (so that the property is included in the surviving spouse’s estate). Each option has its own design hurdles, and should be closely examined when drafting an estate plan.

Taking Advantage of Step-up in Basis

When implementing tax basis planning, you must differentiate assets by how they are affected by basis. For low-basis assets that benefit greatly from a step-up in basis (i.e. founders/creators of intellectual property, publicly traded companies, and real estate development) an effective plan would likely center on allowing the clients to “die with the asset” in order to gain a step-up in basis. The perfect scenario for such a plan is when a client’s estate does not exceed the estate tax exemption amount.

Conversely, for assets that are unlikely to benefit from a step-up in basis (discussed in more detail below), the goal is often to transfer assets out of the estate. Removing high-basis assets from the estate is beneficial only to the extent that the cost benefit of transferring the assets out of the estate exceeds the federal and/or state transfer tax liability.

Asset-by-Asset Analysis

We must now pay close attention to assets that provide maximum income tax benefits from a step-up in basis. A thorough knowledge allows for little or no realized gain upon sale, and/or preferential capital gain treatment. Highly appreciated assets, for example, benefit greatly from a step-up in basis, whereas cash (which always has a basis equal to its face value) provides no step-up benefit.

The following key asset classes provide the greatest benefit from a step-up in basis:

highly appreciated property,
intellectual property,
mortgaged real estate (specifically, property with a mortgage that exceeds the basis),
low basis property, and
depreciated property.

Intellectual property is considered a non-capital asset while in the hands of the creator. However, once received through inheritance, intellectual property is characterized as a capital asset and receives a step up in basis.[vii]

Asset classes providing little or no benefit from a step-up in basis include the following:

Cash,
High basis property,
Assets valued at a loss, and
IRAs and other qualified plans

Cash does not provide any benefit from a step-up in basis because its basis is always equal to its stated value. Importantly, assets valued at a loss will receive a step-down in basis.[viii] Basis adjustment at death would eliminate the loss for both ordinary income and capital assets. For mortgaged real estate, look for instances where the amount of the mortgage exceeds the property’s adjusted basis. This is called “negative basis” and “negative capital”. Gifting negative capital will trigger gain based on the amount that the mortgage exceeds the property’s adjusted basis. Lastly, IRAs and other qualified plans (as well as all forms of IRD) are not entitled to a step-up.[ix] As a result, they are not beneficial from a basis standpoint.

Conclusion

The passage of ATRA ushered in a new era of estate planning; one that focuses on retaining assets in the estate to gain a step-up in basis. Gone are the days where we concentrated primarily on testamentary transfers of assets out of the estate. Further, when funding trusts we need to analyze our clients’ estates on an asset-by-asset basis to ensure that each appropriate asset receives a step-up in basis.

Resources:

The New Estate Planning Frontier: Increasing Basis by Michael A. Yahus, JD, LLM and Carl. C. Radom, JD LLM

Running the Basis and Catch Maximum Tax Savings, Part 1 (January 2015) and Part 2 (February 2015), Paul S. Lee, JD, LLM of Northern Trust.
[i] 26 U.S. § 1012

[ii] 26 U.S. § 1014 and 26 U.S. § 1015

[iii] 26 U.S. § 1014(b)

[iv] Notably, a bypass trust still has significant benefits and should still be used in many circumstances, such as when a client has over the state or federal estate tax exclusion amount.

[v] Section 1014 (b) (1) and 2514(c) defines a general power of appointment as “power exercisable in favor of 1) the power holder, 2) his or her estate, 3) his or her creditors, or 4) creditors of his or her estate.

[vi] Treasury Regs § 2041

[vii] IRC § 1221(a)(3)

[viii] 26 U.S. § 1014(b)

[ix] Per 1014(c), any asset that is income in respect of a decedent will not be eligible for a step-up in basis at death. This is why IRAs, annuities, and other similar qualified accounts do not receive a step up at death

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