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Income Tax – the “Other” Tax in Estate Planning

Income Tax Planning and Coronavirus COVID-19 Relief

Many people are aware of the increased federal estate tax exemptions (approximately $11.2 million plus a COLA adjustment for a decedent dying in 2018 through December 31, 2025 and then reverting to $5.0 plus COLA) along with the elimination of New Jersey estate tax (but not its Inheritance tax which remains in effect).  They, therefore, think that estate taxes are no longer a concern, and accordingly, no tax planning is needed when creating their wills and related estate plan documents.

Overlooked, however, is the importance of income tax planning as part of planning an estate, and in particular, the income tax basis of assets gifted or inherited.

Under the Internal Revenue Code, assets gifted during lifetime retain the income tax basis of the donor, but not in excess of their fair market value at the date of gift.  However, assets inherited upon the death of the owner receive a new tax basis equal to their fair market value at the date of death.  (This is commonly referred to as the “step up” in basis rules).  For example, an asset that cost $100, but has a fair market value of $1,000, would have a tax basis to the done of $100 if received by gift and a tax basis of $1,000 if received by inheritance.

From these income tax rules, there are several significant planning tips.

  1. If an individual’s potential estate is materially below the applicable estate tax exclusions, gifting of appreciated assets during lifetime rarely makes tax sense – gifting will in most cases cause a loss of basis step up.
  2. Any gifting deemed appropriate should be made, whenever possible, with high basis assets.
  3. If the potential estate is large enough that estate tax may be due, consider gifting assets with a high potential for future appreciation.
  4. A situation in which gifting may be advantageous would entail gifts by a New Jersey resident to individuals other than a spouse, an issue or a charity since a bequest to those individuals would be subject to New Jersey Inheritance Tax, which remains a part of the New Jersey law. Even in that case, however, gifting to such individuals would best be made from assets that are not appreciated from their cost basis rules.
  5. Consider undoing trusts that may have been previously created in order to maximize the benefits of the step up in basis.
    • For example, a trust created at the death of a decedent for a surviving spouse (commonly called a “bypass” trust, a “B” trust or a credit equivalent trust), which is holding appreciated assets, might allow (or might be reformed to allow) principal distributions to be made to a surviving spouse to be held by that person till death in order to obtain a step up in basis for those assets.
    • Certain irrevocable trusts created during lifetime might be terminated, with distributions to the grantor or to the spouse of appreciated assets to be held by that person until death.
    • In certain trusts that are treated as owned by the grantor for income tax purposes, a “swap” of higher basis assets in the hands of the grantor for lower basis assets in the trust could be advantageous.
  6. If your existing estate planning includes a trust created on the first death for the benefit of a surviving spouse, based on the rules discussed above, you should review whether revised documents that eliminate the trust would be advantageous.

If you have any questions regarding these items, or in general, regarding your estate plan, please contact one of us in the Estate Planning & Administration Group.