Pay Attention to Income Tax when Creating Estate Plans

POSTED ON: August 23, 2022

Avoidance of estate taxes is one consideration in estate planning, but the estate tax system only applies to the wealthy. The income tax, however, applies to EVERYONE, and improper income tax planning often creates unnecessarily large income tax liabilities for the heirs of middle income Americans.

Pay Attention to Income Tax when Creating Estate Plans

While estate taxes may only be of concern for mega-rich Americans now, in a relatively short time, the federal exemption rate is scheduled to drop precipitously. Estate planning underway now should include consideration of income tax issues, especially basis, according to a recent article titled “Be Mindful of Income Tax in Estate Planning, Particularly Basis” from National Law Journal.

Because of these upcoming changes, plans and trusts put into effect under current law may no longer efficiently work for income tax and tax basis issues.

Planning to avoid taxes has become less critical in recent years, when the federal estate tax exemption is $10 million per taxpayer indexed to inflation. However, the new tax laws have changed the focus from estate tax planning to coming tax planning and more specifically, to “basis” planning. Ignore this at your peril—or your heirs may inherit a tax disaster.

“Basis” is an oft-misunderstood concept used to determine the amount of taxable income resulting when an asset is sold. The amount of taxable income realized is equal to the difference between the value you received at the sale of the asset minus your basis in the asset.  For example, if you purchased property (or any investment such as stock or a collectible) for $20,000 in 1995, your “basis” is $20,000.  If the asset is worth $100,000 today, your “built-in gain” is $80,000 ($100,000 – $20,000), and that is the amount of income (capital gain) that you have.

There are three key rules for how basis is determined:

Purchased assets: the buyer’s original basis is the investment in the asset—the amount paid at the time of purchase. Here’s where the term “cost basis” comes from.

Gifts: The recipient’s basis in the gift property is generally equal to the donor’s basis in the property (called “carryover basis”).  The giver’s basis is viewed as carrying over to the recipient. This is where the term “carry over basis” comes from, when referring to the basis of an asset received by gift.

Inherited Assets:  The basis in inherited property is usually set to the fair market value of the asset on the date of the decedent’s death. Any gains or losses after this date are not realized. The heir could conceivably sell the asset immediately and not pay income taxes on the sale.  The adjustment to basis for inherited assets is usually called “stepped up basis.”  In other words, if you die with that property worth $100,000, your heirs will get the property with a new “stepped-up basis” of $100,000.  Accordingly, planning for this is very important, and failing to get the step-up can result in dire consequences for your heirs.  The federal long-term capital gains rate is 20% and the top Louisiana state income tax rate is 6%.  So gains are most often taxed at approximately 26%.  Therefore, the step-up for that example property alone is worth $20,800 (($100,000 – $20,000) X 26%).  In other words, failure to qualify for the step-up can cost your heirs $20,800 on that $100,000 asset.

Here is the takeaway: Having an estate planning attorney that is also a good tax attorney makes sense to make sure your estate qualifies for the step-up. Basis planning requires you to review each asset on its own, to consider the expected future appreciation of the asset and anticipated timeline for disposing the asset. There is no easy one-size-fits-all rule when it comes to basis planning.

Estate planning requires adjustments over time, especially in light of tax law changes. Many of the strategies and tools used long ago may or may not work in light of the current and near-future tax environment.  Speak with your estate planning / tax attorney, if your estate plan was created more than five years ago.   If you don’t have an estate planning attorney that understands federal tax law, make sure you also consult with a CPA.

BOOK A CALL with me, Ted Vicknair, Louisiana Board Certified Estate Planning and Administration Specialist, Louisiana Board Certified Tax Law Specialist, and Louisiana CPA to learn more about estate planning in Louisiana, incapacity planning, and Louisiana asset protection.

If you liked this article, “Pay Attention to Income Tax when Creating Estate Plans” read also these additional articles: How Changes to Portability of the Estate Tax Exemption May Impact You and What Healthy Snack Is Best for My Long-Term Health? and Who will Receive Naomi Judd’s Estate? and The Biggest Health Mistakes Seniors Make

Reference: National Law Review (July 22, 2022) “Be Mindful of Income Tax in Estate Planning, Particularly Basis”

Success Stories