Patricia M. Annino
Planning at the intersection of income and estate taxes

Changes to the federal estate tax exemption make it increasingly important for advisers to focus on the income tax consequences of estate planning.

January 21, 2014
by Patricia M. Annino, J.D.

The American Taxpayer Relief Act of 2012 (ATRA), P.L. 112-240, significantly increased the federal estate tax exemption in 2014 to $5.34 million (adjusted for inflation) and made permanent portability of the first-to-die spouse’s exemption. The change means many families no longer have to worry about estate taxes. But estate planners who have traditionally overlooked the income tax during planning discussions now need to examine how that tax intersects with estate taxes.

A refresher course on the taxes’ relationship

If no federal estate tax will be due, giving the asset away during a person’s lifetime can result in overall higher taxes paid by the family. Under the ATRA federal income tax rules, capital gains on appreciated assets will be taxed at a 20% rate for taxpayers with taxable income over $450,000 (joint filers), $400,000 (single filers), $425,000 (heads of households) and $225,000 (married taxpayers filing separately). The capital gains tax is either 15% or 0% for taxpayers that are below those thresholds. Also under ATRA, a 3.8% net investment income tax may apply, with a significantly lower threshold. The net investment income tax threshold is based on modified adjusted gross income (adjusted gross income plus any excluded foreign income) and is $250,000 for joint filers, $200,000 for single filers, $200,000 for heads of households and $125,000 for married filing separately.

When the asset is given during lifetime, the recipient takes the income tax basis of the donor if that asset has appreciated (Sec. 1015(a)). The result may be a significantly higher overall tax paid than if the asset transferred at death. In other words, if the donor’s gross estate is less than the federal estate tax exemption, and there is significant built-in gain in the asset, then giving it during lifetime will trigger the gain when that asset is disposed of or sold.

When evaluating the tax cost to a lifetime gift, practitioners also need to consider the state inheritance and estate taxes. For states with an estate tax, the exemption is usually lower than the federal estate tax exemption level, so there may be a state estate tax due even if no federal estate tax is due. Retaining the asset until death may result in no federal estate tax, a state estate tax, and a fresh start income tax basis for income tax purposes. It is important to run the numbers and determine the lowest combination of those three taxes to make an informed planning decision.

If property given during lifetime is depreciated at the time of the gift, the donee takes as the income tax basis the property’s fair market value at the time of the gift—but only for the purpose of taking losses (Sec. 1015(a)). The donee’s basis is increased by all or a portion of the gift taxes paid on the gift transfer (Sec. 1015(d)(6)).

When the bequest occurs at death, the income tax basis receives a fresh start and is stepped up to the date of death value, or the alternate valuation date, if that was elected (Sec. 1014). This occurs even if no federal estate taxes are due, meaning that any gain accrued before the date of death disappears. On the other hand, if the asset was depreciated for loss recognition purposes, the basis steps down at the time of death and loss cannot be recognized.

If the taxpayer is domiciled in a community property state, then the surviving spouse’s share of community property is treated as acquired from the decedent and receives the stepped-up or stepped-down basis even if it was not included in the taxpayer’s federal gross estate (Sec. 1014(b)(6)).

There is a glitch if the decedent had acquired the asset within one year of death and if, at the taxpayer’s death, the asset passes back to the donor or the donor’s spouse. In that case, the basis does not step up (Sec. 1014(e)). From a planning point of view, if the taxpayer’s health is declining, it makes sense, if possible, to make the gift more than one year prior to death and to someone other than the donor or the donor’s spouse.

Another exception to the stepped-up basis rules pertains to what is known as “income in respect of a decedent” under Sec. 691. Sec. 1014(c) provides that these items are to be included in full in the decedent’s gross estate and treated as gross income when realized. Essentially, these assets are taxed twice—once for the estate tax and once for the income tax. There is an income tax deduction under Sec. 691(c) for the estate tax attributable to the inclusion of income in respect of decedent on the decedent’s federal estate tax return.

Examples of assets subject to both taxes include certain salary and fringe benefits accrued at death, fees and commissions for services performed during lifetime and paid after death, and retirement plan assets and dividends. If the taxpayer’s intention is philanthropic, however, donating these assets to a qualified charity qualifies for both the estate and income tax deductions.

In light of the significantly increased federal estate tax exemption, take into account these income tax considerations in determining which assets should be transferred during lifetime, at death, to individuals, and to charities.

Carefully consider the tax consequences of installment sales

The older generation may decide to sell the family business or commercial real estate to the next generation on an installment basis, which freezes the asset’s value for estate planning purposes. With the significantly increased federal estate tax exemptions, however, this may no longer be important. For federal income tax purposes, installment sales allow the taxation to be proportionately spread out during the years that principal payments are made. Since this is a lifetime sale, there is no fresh start basis in the underlying asset and the heir who inherits the note continues to pay income taxes on the payments as they are received.

Determine when charitable gifts should be made

Clients who wish to leave a bequest to a charity need to know that there is no deduction if the estate is not subject to federal estate tax. If the estate taxes are deferred until the surviving spouse’s death, and the charitable bequest occurs through the estate of the first spouse upon his or her death, in all likelihood there will be no federal estate tax and therefore no estate tax charitable deduction. Alternatively, the client may decide to make the gift during his lifetime and obtain the charitable income tax deduction, or he may ask his spouse to voluntarily make it during her lifetime if she survives him and take the income tax deduction. His estate planning documents could stipulate that if the aforementioned action is not taken then the charitable bequest is to be paid when they both die.

The AICPA PFP Section’s Planning After ATRA and the Net Investment Income Tax Toolkit has an extensive collection of resources for PFP Section members and CPA/PFS credential holders to help navigate through the multi-layer tax laws and translate them into clear strategies to assist your clients with their tax, financial, and estate planning. The toolkit includes links to webcasts, podcasts, client communications with Forefield Advisor, and the four-volume The CPA’s Guide to Financial and Estate Planning, updated for ATRA and NIIT.

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Patricia M. Annino, J.D., LL.M., is a nationally recognized authority on estate planning and taxation who chairs the Estate Planning practice at Prince Lobel Tye LLP in Boston.