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Income Taxes are Becoming more Important in Estate Planning

May 15, 2014

For many taxpayers, shifting focus to income taxes in their estate planning is a good idea.

For many taxpayers, shifting focus to income taxes in their estate planning is a good idea. Why? The federal estate tax exemption is $5.34 million for 2014, and it’s scheduled to be adjusted for inflation annually. This means that a lot of taxpayers who would have faced an estate tax liability when the exemption was lower will now be fully protected by it — making income taxes more important.

Plus, federal income taxes have potentially become more costly. The top income and capital gains tax rates have increased to 39.6% and 20% respectively. Plus, the new 3.8% net investment income tax will affect even more taxpayers. (It’s triggered at adjusted gross incomes of $250,000 for joint filers and $200,000 for nonmarried filers.)

Here are a few strategies to consider if federal estate taxes aren’t a concern.

Make bequests, not gifts

If your estate will fall within the exemption, holding on to assets until death can provide your family with tax savings. When you make a lifetime gift, the recipient takes over your tax basis in the asset. This means that, if the recipient sells the asset, he or she generally will owe income tax on any appreciation on the asset while you owned it. But when you bequeath an appreciated asset, the recipient’s basis is “stepped up” to the asset’s fair market value on the date of death. So, if the recipient immediately sells that asset, no income tax will be due.

For example, say a taxpayer has $5 million of assets with a cost basis of $1 million. If the taxpayer dies holding these assets when they’re worth $5 million, the beneficiaries of the estate will receive the assets with a basis of $5 million. If they immediately sell the assets, they’ll pay no taxes on the sale — and end up with $5 million.

Alternatively, let’s say the taxpayer gifted those $5 million worth of assets with the same $1 million basis, and the donees immediately sold the assets for $5 million. Because they take over the donor’s $1 million tax basis, they’d recognize a $4 million gain. They’d end up paying approximately $950,000 in federal income taxes (assuming they don’t have losses to absorb any of the gains) and be left with only $4.05 million — less if state taxes also applied.

The strategy of making bequests, not gifts, doesn’t always work with a larger estate, though. Let’s say our hypothetical taxpayer has two assets — a business worth $1 billion and $400 million in cash. In addition, the intended donees wish to keep the business, and the taxpayer and the business are in a state without a gift or estate tax. If the taxpayer gifts the $1 billion business to the donees, it would generate a $400 million federal gift tax, which could be paid with the $400 million in cash. This would leave the taxpayer with zero and the donees with a business worth $1 billion.

If the taxpayer waits until death to make the transfer, the entire $1.4 billion would be includable in his taxable estate, generating a $560 million tax bill. Not only would the tax bill be higher, but the donees would be left searching for the additional $160 million (beyond the $400 million in cash) needed to pay the estate taxes — or be forced to sell the business in order to pay the tax.

Donate to charity now

Making donations to qualified charities during your life can save more taxes. Lifetime donations generally provide an income tax deduction, whereas charitable bequests provide only an estate tax deduction.

So if your estate falls under the exemption limit, a charitable bequest won’t create any tax benefit. If you give to charity while you’re alive and can use that benefit to offset taxable income, your net estate that goes to your heirs will actually be larger.

Using a very simplistic example and round numbers, let’s say you have $3 million in assets and this year you earn another $1 million in taxable income. If you donate $500,000 to charity and have no other deductions or tax breaks, you’ll pay approximately $200,000 in taxes and end up with $3.3 million. If you die with the $3.3 million and your estate plan doesn’t call for any charitable bequests because you made the lifetime donation, the entire $3.3 million can go to your heirs.

Now the same fact pattern as above, but you don’t donate to charity this year; rather, you include a $500,000 charitable bequest in your estate plan. You’ll pay $400,000 in taxes this year, and end up with $3.6 million. If you die with the $3.6 million, after the $500,000 charitable bequest, your net estate will be $3.1 million — $200,000 less than had you donated the same $500,000 while you were alive.

Consider other tax issues

In some states, state estate taxes may apply even when an estate is within the federal exemption. This is a very important point and should not be overlooked. Also, some states have an estate tax but not a gift tax. Depending on the rates, what you would save in income taxes from the step-up in basis by making bequests rather than lifetime gifts could be completely lost by the estate tax owed to the state.

It’s also important to watch out for tax law changes. Although the high, inflation-adjusted exemption has no expiration date, it’s possible that Congress could pass legislation in the future that would reduce the exemption.

If you’re not sure whether estate taxes or income taxes could be more costly to your family, please contact us. We can estimate the size of your taxable estate and help determine the strategies that are right for you.

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