Tax Basis Planning Strategies

Take-Away: With the continued increase in the applicable exclusion amount resulting in fewer and fewer taxable estates [it’s $5.6 million per taxpayer beginning in 2018] income tax basis planning has become increasingly important, especially when there is an opportunity to avoid federal estate taxes and still obtain a ‘step-up’ in the income tax basis of assets.  Several strategies exist where the income tax basis of an asset can be increased on an individual’s death, even after the asset has been transferred during lifetime. What follows are some strategies that can  expose assets to an income tax basis increase on an individual’s death that should be kept in mind during annual reviews with clients and the discussion turns to end-of-the-calendar-year gifts.

Tax Background: Basis is generally the owner’s capital investment in an asset for income tax purposes. The basis of an asset is the cost to acquire it. The cost is the amount paid for the asset in cash, debt obligations, and other property and services. Cost basis also includes sales taxes and other expenses that were incurred in the purchase of the asset. Basis is adjusted to reflect costs of improvements that add to the asset’s value, and basis is decreased by allowable depreciation associated with the asset.  IRC 1011.

• Carry-Over Basis: If the asset is the subject of a lifetime gift there is a ‘carry-over’ of its income tax basis from the donor to the donee. IRC 1015.
• Step-Up in Basis: If the asset is held until the donor’s death, the basis of the inherited asset is adjusted to its fair market value as of the date of death. IRC 1014. Consequently,  those heirs who inherit an asset take a ‘fresh-start’ income tax basis in the asset for capital gains tax calculations. Note, though, that the income tax basis could also go down, as it is the date-of-death value that determines the new basis in the name of the heir who inherits the asset.
• Spousal Basis Rules: If the asset was jointly owned by spouses, the income basis in the asset is adjusted equal to 50% of the asset’s fair market value as of the date of death of the one spouse. IRC 2040. If the spouses owned the asset in a community property state, there is a 100% basis adjustment to the asset’s fair market value on the death of one spouse. IRC 1014(b)(6).

Planning Objective: If an individual’s estate is not large enough to create an estate tax concern, or their available federal estate and gift tax credit, the applicable exemption amount, covers all estate taxes due at death,  the opportunity  exists to obtain an increase in the income tax basis of assets which have a fair market value greater than the asset’s date-of-death income tax basis. The obvious goal is to position the appreciated assets to be included in the individual’s taxable estate so that the income tax basis of the asset will be adjusted (hopefully upward) to its fair market value as of the date of the individual’s death, and that the recipients of the inherited asset after the owner’s death can sell the asset without paying capital gain taxes, or they can commence depreciation deductions starting with a new, higher, depreciable value for the asset. IRC 1014 .

Basis Planning Strategies: When meeting with clients to discuss their end-of-the-year planning opportunities, keep in mind some of these strategies:

1. Avoid a Basis Step-Down on Death: If the individual holds an asset with a built-in loss reflected in its current value, that asset will have its basis ‘stepped-down’ on the owner’s death. If in poor health the owner should consider selling the asset at a loss while still alive, and then use the loss recognition to off-set other assets that are contemporaneously sold by the owner at a gain.
2. Use A Note as the Subject of a Gift: If a lifetime gift is contemplated, but the only asset available is one with a low income tax basis (compared to its current fair market value) rather than gift the low basis asset with the continued low basis in the hands of the donee, consider giving the donee a promissory note from the donor. The donor’s note  will come due on the donor’s death; the note can then be satisfied by the donor’s estate using the sales proceeds from the low basis (now ‘stepped-up’ on the owner’s death) asset.
3. Exploit Reverse Gifts: The appreciated asset might be gifted to an individual who does not have a taxable estate, so that the asset’s basis will be adjusted on the donee’s death. However, the Tax Code prohibits the transfer of an asset to another by gift, and then re-acquiring the same asset from the deceased donee with a higher income tax basis, if that death occurs within one year of the original gift. IRC 1014(e). This ‘reacquire’ prohibition however does not apply to third persons who inherit the asset. Example: I own an appreciated asset. I gift the appreciated asset to my mother, who does not have a taxable estate. On my mother’s death, she bequeaths the asset to my children (not to me.) Since I did not reacquire the asset from my mother on her death, the ‘reacquire’ rule does not apply, even if my mother dies shortly after I made the gift to her. The gifted asset’s basis will be adjusted on my mother’s death to its then fair market value. When my children sell the inherited asset, they will pay little or no capital gain due to the basis step-up on their grandmother’s death. Had I gifted the appreciated asset directly to my children and they then sold the asset, they would have had to pay a capital gain tax. [You’ll recall that I previously referred to this as free-basing with grandma.]
4. Exploit Portability: A surviving spouse can ‘inherit’ the deceased spouse’s unused federal applicable exemption amount. This portability election of the unused applicable exemption amount must be made on a timely filed federal estate tax return. The result of a portability election is that the surviving spouse can own more assets without fear of incurring a federal estate tax on the survivor’s death, while exposing those additional assets to a second basis ‘step-up’ on the survivor’s death. Recall that if the asset is owned by the spouses jointly or by the entireties there will only be a basis increase of 50%. If there is a concern about creditor protection for the surviving spouse,  the deceased spouse’s assets should pass directly into a QTIP marital deduction trust for which a portability election is made. The QTIP trust assets will receive a ‘step-up’ in basis on the survivor’s death, despite being held in the name of the QTIP trust. Will and trust provisions should be reviewed to confirm that a portability election can be timely made and that they clearly direct the decedent’s estate fiduciary to make that portability election and to pay for the cost to prepare and file a Form 706 on which the timely portability election must be made, even though no estate tax is due and the Form 706 does not have to be filed. In sum, there should be an affirmative duty imposed on the estate fiduciary to elect portability, especially in a second marriage situation where the decedent’s children from a prior marriage will not benefit from a portability election and will resent spending estate assets in preparing and filing a Form 706 which in their mind only benefits their step-parent and his/her descendants and not them.
5. Identify Community Property: If spouses acquired assets while residing in a community property jurisdiction, as noted above, there will be a 100% step-up in the basis of those community property assets on the death of one spouse. Even though the spouses now live in a common law jurisdiction, e.g. Michigan, the community property character of the assets will not change, so long as the survivor can demonstrate that the assets were initially acquired or accumulated in the community property jurisdiction during the marriage and the intent is to hold them as community property. Some spouses create a joint trust to hold and segregate their community property assets from their common law assets. Other spouses enter into an agreement in which they expressly identify their community property assets that they previously acquired, while memorializing their mutual intention to preserve the community property character of those assets even though they no longer live in a community property state. As previously reported, Michigan is currently looking at the adoption of a statute which would permit Michigan spouses to declare that assets held by them are intended to be treated as community property, even though the spouses never set foot in a community property state. That is not the law today, but it is something that may soon appear in Michigan as one more option to gain a 100% basis increase to all of the assets held in that community property trust on one spouse’s death.
6. Assure a Partnership IRC 754 Election: When a partner in a partnership dies IRC 754 allows the partnership to make an election to have the deceased partner’s basis adjusted to equal the deceased partner’s new ‘stepped-up’ outside The successor partner to the decedent acquires a new tax basis in the decedent’s share of the underlying partnership assets as if he/she had purchased an undivided interest in those assets at fair market values on the partner’s death. This inside basis ‘step-up’ is limited to the decedent partner’s outside basis ‘step-up’ as of the date of death. Only the deceased partner’s or the successor partner benefits from this election; the remaining partners receive no benefit. The partnership agreement should be reviewed to assure that a timely IRC 754 election will be made which benefits only the successor/inheriting partners.
7. Gift Income-in-Respect-of-Decedent Assets to Charity: Income in respect of a decedent (IRD)  assets that do not have an income tax basis, e.g. cash, unpaid deferred compensation benefits; IRAs and 401(k) accounts; a promissory note. An IRD asset is not subject to an income tax basis adjustment on the death of its owner- it has no basis. Consequently, IRD assets are best left to a tax exempt entity. Thus ‘no-basis’ assets should be allocated to charities that do not pay any income tax on the disposition of the IRD asset, while higher basis capital assets (which are stepped-up on the owner’s death) should be allocated to non-charitable beneficiaries. Wills, trusts and beneficiary designations should all clearly direct that IRD assets be used to fulfill charitable bequests, if any,  or that IRA beneficiary designations used to satisfy any charitable bequests rather than basis-adjusted capital assets.
8. Turn the Tables on the IRS- Exploit IRC 2036: The value of the gross estate of a decedent includes the value of property that was transferred during the decedent’s life to someone else if the decedent retained “for his life, the possession or enjoyment of, or the right to the income from the property, or the right, either alone or in conjunction with any other person, to designate the persons who shall possess or enjoy the property or the income.” IRC 2036(a). This is often called a string provision of the Tax Code as it brings back into the decedent’s taxable estate assets that were previously transferred, i.e. gifted, by the decedent. Frequently the IRS has invoked IRC 2036 when a family partnership or LLC was created and interests in that entity were transferred by the parent to children, arguing that the parent retained sufficient control over the transferred assets that the value of all of the entity’s assets should nonetheless be included in the donor’s taxable estate at his or her death. If the donor’s estate falls below the estate tax exclusion amount and whose lifetime use and enjoyment of the transferred asset might fall within IRC 2036, consider exploiting that application and create a ‘paper-trail’ that demonstrates that IRC 2036 applies. For example, if a parent made a lifetime gift of their appreciated cottage to their children, but the parent continued to use the cottage after the gift while held in the names of the children, an agreement that gives the parent the right to use the cottage, rent-free, would be sufficient to show that the parent retained a lifetime use of the cottage sufficient justifying their estate to assert that IRC 2036 applied to the cottage, and therefore the fair market value of the cottage should be reported as part of the deceased parent’s taxable estate, leading to an increase in the tax basis of the cottage. Similarly, if the family engaged in a family LLC arrangement years ago, but now it appears that the parents have no federal estate tax exposure, IRC 2036 might warrant some self-serving documentation that shows that the parents retained control of all of the LLC’s income, which then permits the children to claim that the entire value of the family LLC should be included in the deceased parent’s taxable estate, leading to an income tax  basis ‘step-up’ of all of the assets held in the name of the family LLC.
9. Testamentary Power of Appointment: You have heard about this strategy before from me, as well. If a trust protector is authorized under an irrevocable trust to grant to a lifetime beneficiary of the trust a testamentary general power of appointment, the protector can give that general  power of appointment to the trust beneficiary if the value of the trust’s assets, when added to the trust beneficiary’s own ‘outside’ assets, will not result in any federal estate tax exposure. Merely holding a testamentary general power of appointment, whether it is exercised or not, is sufficient to cause the value of the trust’s assets to be included in the power holder’s taxable estate. The trust protector could give the trust beneficiary the power to appoint only specific assets held in the trust, such as those assets with low basis and which would benefit the most if there was a basis ‘step-up’ to those assets on the power holder’s death. If there is a concern that the power holder might go ‘rogue’ and actually divert the trust’s assets by the power of appointment’s exercise, the power of appointment granted by the trust protector could be narrowed to be exercised solely for the benefit of the power holder’s estate creditors, yet that narrow power of appointment would still cause all of the assets held in the name of the trust to have a basis adjustment on the power holder’s death.
10. Exercise Grantor’s  Retained Power to Swap Assets: If an individual has previously created an intentionally defective grantor trust, and sold assets to that trust, the intended grantor trust treatment was probably a result of the grantor deliberately retaining the power to substitute assets of equivalent value with the assets held in the name of the trust. IRC 675(4)(c). If the grantor is in poor health and death is on the near horizon, the grantor might consider exercising the retained power of substitution, and exchange high basis assets then held by the grantor with the low basis assets then held in the name of the trust. Thus, when the grantor’s death arrives, the grantor will own low basis assets that will be adjusted upward to their fair market values at the owner’s death. Alternatively, the grantor could purchase the low basis assets from the trust, which so long as it remains a grantor trust for income tax reporting purposes, results in no gift or income tax consequence to the grantor, again leaving the grantor the owner of low basis assets upon the grantor’s death.

Conclusion:  You can expect to spend a lot more time as this calendar year comes to a close talking with clients about income tax basis rather than estate tax avoidance strategies. Knowing what to look for and being familiar with some of the strategies used to exploit existing tax laws, and in some cases turning the IRS’s arguments against itself, will add value to the discussions about end-of-the-year gifting opportunities, and the implications of ‘carry-over’ income tax basis that results from lifetime gifts.