When I am speaking with many of my clients regarding their estate planning the conversation is usually about the transfer of their wealth to the next generation, or it is planning for their future incapacity, or planning for a smooth estate settlement, or even the planning to protect their children's inheritance from divorce and creditor claims. However, very rarely, the conversation almost never includes tax planning. Unfortunately, this is where a lot of attorneys can perform a disservice to their clients.
Every conversation about estate planning should include the topic of tax planning, specifically, income tax planning.
The most common tax that Tennessee families think of when it comes to estate planning is the death tax. However, less than 1% of families need to even worry about the death tax. Under current estate and gift tax legislation, the estate tax (commonly referred to as the death tax) only applies to the transfer of wealth above $5.49 million (or $10.9 million for married couples) for those dying in 2017. Therefore, many Tennessee families do not have an estate tax planning issue. However, almost every estate will have an income tax planning issue.
The most common issue is to protect the step up in tax basis. When you purchase an asset that appreciates in value over time, the cost in which you paid for that asset is usually the basis. For example, you bought 100 shares of Microsoft in 1990 for $5,000. In this case your basis for that stock would be $5,000. If you later sold that same stock in 2010 for $15,000, you would have a taxable gain (referred to as a capital gain) of $10,000 that would be taxed at the appropriate capital gains tax rate.
How does this impact estate planning? Well, there are two tax concepts called "carry over tax basis" and "step up in tax basis." When an asset transfers at death, the asset will normally receive a step in tax basis. What this means is that the tax basis for the property is what it is worth on the date it is transferred at death. For example, using the example above, if John transfers his Microsoft stock to his son, Jim, at death when it is worth $25,000, then the stock would have a basis of $25,000 and not $5,000. If Jim later sold the stock for $25,000, he would owe no capital gains taxes.
However, there is also a concept called carry over tax basis. This is a tax concept where you receive the original tax basis of the property. This is normally the case when you gift an asset that appreciates in value to another person during your lifetime. For example, and using the example above, let's say that instead of the Microsoft stock transferring at death, it instead transfers via a gift to John's son, Jim. If Jim later sold the stock for $25,000, he would owe capital gains taxes on the $20,000 gain as he received his father's $5,000 carry over tax basis.
As you can see, estate planning also includes income tax planning. However, how can a family benefit from this further? Well, under normal circumstances, when a married couple owns an asset that appreciates in value, such as stock (as in the example above), when it transfers at death to the surviving spouse, the surviving spouse only receives a step up in tax basis equal to one-half of the value of the asset. For example, and using the example above, if the Microsoft stock transferred at death to John's wife, Mary, she would not receive a 100% step up in tax basis to $25,000. Instead, only one-half of the Microsoft stock would receive that step up.
However, if John and Mary had established a Tennessee Community Property Trust, then Mary would have received a 100% step up in tax basis to the entire Microsoft stock and could later sell and liquidate that stock at the complete step up value, and incur no capital gains taxes. Which would be a substantial tax savings for Mary.
If you have additional questions about estate planning, tax planning, and income tax planning, please download our free report on estate planning and income tax planning to the left of the screen. Just fill out the contact form and we will e-mail a copy of this Free Report to you immediately so you can have it in hand.
Should you have any questions, please reach out to us directly. As always, we are here to help.
Daniel A. Perry
Attorney at Law