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Planning Your Estate
Dealing with Asset Basis
By Roger Wohlner
CERTIFIED FINANCIAL PLANNER™ Practioner, Asset Strategy Consultants
Deciding whether you should give a significant asset to an heir during your life or after your death has typically involved weighing potential estate tax costs against capital gains taxes that would be due when the asset is sold.
You can make annual gifts, up to $12,000 in 2006 ($24,000 if the gift is split with your spouse), to any number of individuals without paying federal gift taxes. There is also a lifetime gift exemption of $1,000,000 ($2,000,000 if the gift is split with your spouse). The basis of any gift made during your lifetime equals your basis plus any gift taxes paid on the gift.
The estate tax exclusion increased from $1,500,000 in 2005 to $2,000,000 in 2006 and will increase again to $3,500,000 in 2009. The estate tax rate is 46% in 2006 and will drop to 45% in 2007. The basis of any asset distributed to heirs after your death is stepped up to fair market value on the date of your death. The significant increase in the exclusion amount means that assets with fairly significant values can be transferred to heirs without paying estate taxes, while still stepping the bases up to fair market value. However, keep in mind that the estate tax will be repealed in 2010, with special rules in effect for basis adjustments for that year. In 2011, the estate tax will be reinstated based on 2001 tax laws.
Thus, when making gifts, you have historically needed to evaluate whether it was better to make the gift after death so your estate will pay estate taxes or during your lifetime so your heirs will pay capital gains taxes when the asset is sold. Now that the estate tax exclusion amount is so high ($2,000,000 in 2006), many individuals do not need to focus on estate taxes. Instead, gifts should be made in a manner that will reduce overall income and capital gains taxes for the family. Some strategies to consider that may help accomplish this objective include:
Transfer low-basis assets after death. When heirs receive an asset that has increased significantly in value after your death, its basis is stepped up to market value. They retain your basis when it is received during your lifetime, so significant capital gains taxes may be due when the asset is sold. However, if you plan to sell the asset in the near future, you should consider the tax impact if you own the asset or your heirs own the asset. Especially if you are going to use the proceeds for your heirs' benefit anyway, there may be a lower capital gains tax bill if your heirs sell the asset. Capital gains taxes are currently 15%, but taxpayers in the 10% or 15% tax bracket only pay 5%.
Consider using an estate defective trust (EDT) to transfer significant low-basis assets. Once the asset is placed in trust, any income from the asset is allocated to the trust or the trust beneficiaries, who will typically be in a lower tax bracket. However, the asset is still considered part of your estate, so heirs will receive a step-up in basis after your death.
Reevaluate buy-sell agreements for businesses. Often, buy-sell agreements are funded with life insurance. If one owner dies, the other owners use the life insurance proceeds to purchase the deceased owner's shares. If the life insurance is owned by the company, the proceeds are paid to the company and the remaining owners do not receive a step-up in basis. If each owner owns life insurance on the other owners, the proceeds will be paid to each remaining owner. Those owners can then use the proceeds to purchase shares from the company at fair market value, in essence receiving a step-up in basis.
Review discounting techniques carefully. Many estate planning strategies have involved the use of discounts to reduce the fair market value of the transferred assets. For instance, individuals who transfer noncontrolling interests in businesses, farms, real estate, and other assets may be able to assign a minority interest discount to the gift's value. Now, as long as the gift won't result in the payment of gift or estate taxes, your primary goal will be to increase the basis as much as possible.
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