Basis is Everything
Focus on Basis Planning
For many years, the focus of estate planning was to transfer assets out of an individual's estate in order to minimize the estate taxes that would be due. Since assets gifted during lifetime do not receive a step-up in cost basis (as they would if they passed when someone dies), this strategy accepted the fact that a significant capital gains tax could result upon sale of gifted assets. Nonetheless, since estate tax rates were significantly higher than capital gains tax rates, paying gains tax on a sale of property was better (cheaper) than paying estate tax on that property. Tax law changes over the past several years have radically changed this focus.
First, the amount that can pass to an individual's loved ones (in addition to unlimited gifts to a surviving spouse or qualified charity) exempt from federal estate and gift tax is now $5,450,000 as of January 1, 2016, and will be adjusted for inflation going forward. In addition, the "portability" provisions of the federal tax code allow any unused portion of that exempt amount to be added to the surviving spouse's individual exemption. This means that a married couple can currently pass $10,900,000 to their chosen individual beneficiaries without incurring a federal estate tax. (Note: there may still be state estate tax due, but these state taxes are significantly lower than the federal estate tax rate of 40% on property in excess of the exemption amount.)
For those whose assets are less than the current federal exemption amount, the only tax game is basis planning. Assets that pass when someone dies receive a "step-up" in tax basis to the date of death value, so that a later sale will generate capital gains tax only on the increases in value after the decedent's date of death. This virtually eliminates the tax incentive for gifting for many individuals (though of course there are many other reasons to give). Even where a state estate tax will apply, the increased capital gains tax rates and the imposition of the Medicare surtax result in a situation where any payment of state level estate tax is still likely to be less expensive than payment of capital gains tax.
For those high net worth individuals who continue to be subject to federal estate tax, the focus of basis planning will generally be to maximize the value of the "step-up." Care will be taken to ensure that low basis assets that are expected to be sold will remain as part of an individual's estate to receive the step-up in basis. Gifting to minimize federal estate tax now favors assets intended to be held long term (such as a family vacation home) or at least those with a high cost basis.
More Work for Executors: Form 8971
The Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 requires executors who are required to file an estate tax return on federal Form 706 (or related forms in the 706 series) to make an additional filing to report the estate tax value (in other words, the income tax cost basis) of property distributed to beneficiaries of an estate. This new requirement clearly applies to gross estates over the $5,450,000 exemption amount ($5,430,000 if the date of death was in 2015, and $5,340,000 if the date of death was in 2014) for estate tax returns filed after July 31, 2015. The first due date for this filing is March 31st, with filing required within 30 days of the Form 706 filing date moving forward. There are a number of unresolved issues with the new form, especially since it requires specific information on assets passing to each beneficiary on a Schedule A attached to Form 8971. This schedule is also provided to each beneficiary, and is intended to prevent a beneficiary from claiming a cost basis higher than what was reported to the IRS as the estate tax value of the asset. Though the IRS has not clearly said so, the requirement does not appear to apply to estates filing Form 706 solely to elect portability.
Significant penalties apply for failure to comply, making the executor's work, and the cost of settling affected estates, that much greater. There are many devils in the details of this new requirement, and it is hoped that further guidance will be issued by the IRS soon.