Estate Planning and the Capital Gain Tax – Part II

Part I of this article ended with a question being raised as to whether it is possible that the elimination of liability for estate and gift taxes for most people has actually brought about an increased liability for other taxes, capital gain taxes in particular. In Part II, we will attempt to find the answer.

The tax laws provide that when a person makes a gift of an asset to someone during his or her lifetime, the recipient’s basis in the asset for income and capital gain tax purposes is the same as that of the person making the gift (i.e. usually the purchase price paid for the asset). Therefore, if that share of IBM stock we talked about in Part I of this article which had been purchased for $60.00 but was worth $100.00 on the date of the owner’s death had been gifted to someone while the owner was still alive, the recipient’s basis in the stock would have been $60.00 and would have remained $60.00 following the original owner’s death. It would not receive a new basis at that time. For an adjustment in basis to occur, the stock has to be included in the original owner’s estate. So, if the recipient of the stock would later sell the stock for, say, $120.00, he or she would recognize and pay tax on a capital gain in the amount of $60.00 (i.e. $120.00 minus his $60.00 basis). On the other hand, if the original owner of the stock had retained the stock until his death and left the same stock to the same heir at that time and the heir again sold it for $120.00, the heir would only recognize and pay tax on a capital gain of $20.00 (i.e. the $120.00 sale price minus his $100.00 adjusted basis). A big difference!

The increased estate tax exemption has brought about another way of indirectly causing increased liability for capital gain tax. The typical estate plan model for a husband and wife for the past thirty years has provided for the creation of “by-pass trusts” or “credit shelter trusts.” Regardless of the name given to them, these trusts were designed to utilize the estate tax exemption of the first spouse to die by placing assets of that amount in trust for the benefit of the survivor. The assets placed in such a trust were not subject to estate tax in the first spouse’s estate because of his or her estate tax exemption and were designed in such a way to keep the trust assets from being included as part of the survivor’s estate for estate tax purposes, thus allowing the assets to pass through both estates tax-free. They made complete sense under the estate tax laws in effect at that time.

Trusts of this type saved huge amounts in estate taxes in their day, but for a person now whose estate is less than $11,400,000.00 and is likely to stay under that amount, these trusts may no longer be necessary and may, in fact, cause additional capital gain taxes to be paid when the assets of the trust are distributed to and then sold by the heirs of the husband and wife after their deaths. The reason, very simply, is that the assets held in a typical by-pass or credit shelter trust, not being included in the survivor’s estate for tax purposes, will not receive the basis adjustment allowed under Section 2014 at that time. As a result, any increase in the value of the asset occurring between the death of the first spouse and the death of the survivor, instead of being forgiven, will be taxed in full for capital gain tax purposes, with any increase in value occurring thereafter.

Avoiding the capital gain tax is more important than ever. Not only has the rate increased to 20%, but there is an Affordable Care Act surtax of 3.8% on capital gains in excess of a certain minimum. What should you do? Talk to an estate planning attorney to evaluate your risks on these matters and formulate a plan to minimize the overall impact of both the estate tax and the capital gain tax. If you are married and if you and your spouse have trusts which leave everything in trust for each other first, and then, after the second one of you dies, the estate passes to your heirs, determine if the trust is designed in a way that will allow the assets to be included in the survivor’s estate for tax purposes and receive a basis adjustment at that time. By doing so, you can lessen their liability for capital gain tax in the future.

All these changes in the tax law over the past few years have created many opportunities for planning. But as a result of the tradeoff between estate tax and capital gains tax which has been affected by these recent changes, the planning process has, in many ways, become more complex. Plans which have not been examined since January of 2013 are probably due for a thorough review.