Current Estate Planning – Tax Considerations
The interplay between basis, estate tax, and income tax requires that the estate planner take into consideration a number of factors (i.e., basis, growth potential, appreciation, federal and state estate taxes, and income and capital gain taxes) in order to determine if lifetime transfers are appropriate, and, if so, the proper asset and transfer strategy. This is true regardless of the size of the estate.
Interrelationship between Federal Estate Tax and Capital Gain Tax
Estate planning is less about estate taxes and more about income taxes. This is because the federal estate tax exemption is currently $5,430,000 ($10,860,000 for a married couple) and is indexed for inflation. For those states that still impose an estate tax[1], of which Massachusetts is one, state estate tax planning is still a consideration. You may want to refer to other articles I have written on this subject, but for purposes of this article I will assume that the current federal exemption will remain in place.
From an income tax perspective, it is important to recognize the current estate tax treatment of appreciated assets at death. At present, there are two interrelated factors that provide significant tax savings to individuals who own appreciated assets. First, if the gross estate is less than the federal exemption, there is no federal estate tax. Second, if an appreciated asset is owned at death, the asset will receive a “step up” in basis to its fair market value at the date of death. The “step up” provision effectively eliminates the capital gains tax on appreciated property transferred to a taxpayer’s heirs at his or her death. These benefits are best explained by example. Assume a married couple has a federal gross estate of $3,000,000 of which $1,000,000 is comprised of assets that have a cost basis of $200,000, and therefore a potential capital gain of $800,000 if it sold during their lifetime. Assuming a capital gains tax rate of 23.8%, the tax on the sale of this asset would be $190,400. However, if it were held until the death of the survivor, and sold by the heirs one day later, there would be no tax at all. This is because the basis of the asset is “stepped up” to its estate tax value at death, so that no capital gain tax is ever paid on the appreciation prior to death.
President Obama has proposed to eliminate this “step up” at death by treating bequests and lifetime gifts (with some notable exclusions) as a sale of the asset for income tax purposes. No one can predict whether this proposal, or some variation thereof, will become law, but it is important to note that one of the benefits of the increased federal exemption amount, at least for now, is the potential to eliminate any tax on appreciated assets owned at death, and this is deemed by many to be a tax loophole that needs to be closed.
Additional Implications for the Ultra Wealthy
Most tax strategies for the ultra-wealthy (over $5,430,000 for a single individual and over $10,860,000 in value for a married couple) involve a lifetime transfer of assets designed to remove any future appreciation on the transferred asset from the transferor’s federal taxable estate.[2] In most cases the planning will involve a transfer of a capital asset with long term appreciation potential because that presents the greatest opportunity for estate tax savings. The transfer may be a direct gift or a sale to an Intentionally Defective Grantor Trust (“IDGT”). In either case, the transferee assumes the transferor’s basis in the asset without any capital gain recognition.
Lifetime transfer planning in order to remove future appreciation from the estate tax base is a very complicated process, and is fraught with a number of adverse personal considerations and unknowns, including, but not limited to, relinquishing the loss of the transferor’s access to income on the asset transferred, the loss of some control, valuation issues, unknown asset growth, client lifetime income needs, domicile at death, and future changes in the tax laws. In addition, there is the cost and complexity of preparing and filing a properly-completed gift tax return and the administration costs of the strategy adopted.
For the ultra-wealthy, the complexity of lifetime transfer versus the increased tax cost at death is a significant consideration. The difference in the overall estate and capital gain tax rates on the value of the appreciation of the asset is 16.2% (the assumed federal estate tax rate of 40% and the assumed capital gains tax rate of 23.8%). By way of example, assume a lifetime transfer of a $1,000,000 asset with a $500,000 basis that grows to a value of $2,000,000 at the transferor’s death. The potential tax savings in the gift scenario is $243,000 (16.2% x $1,500,000). If the asset grew in value to $4,000,000, the potential tax savings in the gift scenario is $567,000 (16.2% x $3,500,000). Obviously, the gift scenario is a better tax choice, but is it worth the complexity, cost, and loss of control? The tax cost, whatever it may be, may be mitigated by insurance as discussed below.
Life insurance – A Simple and Effective Solution to the Estate and Income Tax Issues for Estates of all Sizes
Life insurance is an alternative solution for estates of all sizes. I say this because irrespective of whether or not the “step up” rule is altered, or the size of the estate is more or less than the applicable federal exemption, it makes economic sense and is extremely affordable and effective when implemented with proper counsel.
It can be designed to provide funds with which to pay any future tax liability, whether it is an estate tax, an income tax, a capital gains tax, a combination thereof, or for personal family needs. It is important to note that the most important consideration in purchasing a life insurance policy is the health of the insured at the time the insurance coverage is applied for. That is why it must be purchased while healthy. It is not something to be added on at a later date, but rather, it is an integral part of the overall estate plan process. To those who says it is too expensive, I offer the following examples of a current assumption non-guaranteed universal life policy options available today[3]:
- Insureds: Husband (age 70), wife (age 68).
- Health classification:
- Non-smoker preferred best
- IRR on death at age 95: 7.38% after tax
- Annual Premium: $6,405 per $500,000 of coverage
- Non-Smoker Standard
- IRR on death at age 95: 6.37% after tax
- Annual Premium: $7,521 per $500,000 of coverage
- Non-smoker preferred best
- Health classification:
The IRR (internal rate of return) represents the after-tax death benefit return based upon annual payment of policy premiums and assuming death at the younger age 95. The equivalent pre-tax return is the IRR grossed up for taxes. Assume, for example, that the annual premium amount is invested in a taxable investment that is taxed on the annual income/growth at a tax rate of 20%. The pre-tax equivalent return at age 95, under these assumptions is 9.23% and 7.96% respectively.[4] Different assumptions will produce a higher or lower pre-tax equivalent return.
If you would like more information on this subject, or have a client who might benefit from a discussion about it, please contact Barry Koslow at bkoslow@mkaplanners.com or (781) 939-6050.
Securities offered through Advisory Group Equity Services, Ltd., Member FINRA/SIPC. 444 Washington Street, Woburn, MA 01801 (781) 933-6100.
This article should not be considered as providing accounting, business, financial, investment, legal, tax, or other professional advice or services. It is not a substitute for such professional advice or services, nor should it be used as the basis for any decisions or actions that may affect your business or you personally. This should only be one part of your research. You should seek authoritative guidance from a qualified accountant or attorney before taking any action.
© MKA Executive Planners, 12 Gill Street, Suite 5600, Woburn, MA 01801 800-332-2115
[1] For 2015, 19 states plus the District of Columbia impose an estate or inheritance tax.
[2] I am ignoring valuation discounts, installment sale interest, and the annual gift tax exclusions for simplicity
[3] This is not the only policy type available, and there are other policy types depending on the insured’s risk/reward profile.
[4] 7.38%/(1-20%) = 9.23%, 6.37%/(1-20%)= 7.96%
