ESTATE AND FINANCIAL PLANNING: Basis Harvesting

Vol 29 No 2

By

Terence S. Nunan is a member of the Los Angeles, California, firm of Rutter Hobbs & Davidoff, Inc.

 

People do estate planning for two reasons: to make certain their assets pass to their intended beneficiaries and to save taxes for their beneficiaries on and after their deaths. The recent passage of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (Tax Act), which provides a $5 million per person estate tax exclusion, has, for most upper-middle-class persons, made the second objective fairly easy to achieve. For most “ordinary” well-to-do persons, the need for more complicated estate planning devices such as qualified personal residence trusts (QPRTs), grantor retained annuity trusts (GRATs), and defective trusts would seem diminished in light of this $5 million exclusion. The last five years of federal estate taxation have been very unpredictable, and it is possible that the $5 million exclusion will be allowed to lapse in 2013. It seems more likely, however, that the exclusion will be retained.

The Tax Act also adds the new portability provision of IRC § 2010(c), which allows the first spouse who dies to transfer the unused estate tax exclusion to the surviving spouse for use on his or her subsequent death. Finally, the Tax Act allows the reinstatement of the provisions of IRC § 1014 requiring a readjustment of the basis of capital assets of a decedent to the fair market value at the time of death.

For most married couples, the Tax Act will permit a husband and wife to leave all their wealth in trust for the benefit of the surviving spouse and then to children and grandchildren without any estate tax. In theory, the portability feature of the Tax Act permits the first spouse who dies to leave all his or her assets outright to the surviving spouse and rely on the surviving spouse to leave all his or her assets to the children, using the combined estate tax exclusions of both spouses to avoid any estate tax on the first $10 million in assets. But in a world of second marriages and creditors, many spouses will probably want to continue to leave their estates in trust for the benefit of the surviving spouse with eventual distribution to the children on the surviving spouse’s death. There is, however, a disadvantage with this very sensible and very common estate plan. If the surviving spouse lives for ten or 20 years after the first spouse’s death and some of the assets held in trust have significantly appreciated in value, the assets held in trust will forfeit the opportunity to obtain a higher income tax basis on the second spouse’s death.

Under the new Tax Act, if a husband and wife collectively have $6 million of community property assets consisting of a house with a value of $2 million, an apartment building worth $2 million, and an interest in a family business worth $2 million, on the husband’s death in 2011, all these assets, including the surviving spouse’s one-half interest, will get a new income tax basis equal to their date-of-death value. The husband would have a $5 million estate tax exclusion, of which only $3 million would be consumed by the value of his half of the assets, and no estate tax would be owed by the husband’s estate. Assume, for this example, that the husband leaves his entire half of the assets in a bypass trust for the benefit of the surviving spouse and eventual distribution to their joint children.

The portability rule of IRC § 2010(c) also will allow the husband’s estate to pass to the wife the $2 million of unused exclusion that the husband’s estate did not consume. When the wife dies ten years later, her estate will have $7 million of estate tax exclusion available to exempt her assets from estate tax. Assume that on her death, in 2021, her half of the house is now worth $2 million and her half of the apartment building is now worth $3 million, but her half of the family business has declined in value to $400,000. The wife’s estate will have no estate tax to pay because her estate is worth only $5.4 million and she has a total of $7 million of estate tax exclusion, if there has been no change in the law.

Although the one-half portion of the house and the apartment building owned by the wife will obtain a new higher basis on her death, the portion of each of these assets held in the bypass trust for her benefit will be stuck with the old basis, which was fixed at the husband’s death in 2011. If there were some way to include selected assets held in the bypass trust in the taxable estate of the wife, so that her total taxable estate was closer to $7 million but without giving her the ability to change the trust beneficiaries, then the children could inherit the assets in the trust on the wife’s death with a higher income tax basis and still have no estate tax to pay.

There may be a way to obtain the higher basis. If the wife was granted a testamentary general power of appointment under IRC § 2041 over all or selected assets of the trust resulting in inclusion of such assets in her taxable estate, then the children could get a higher income tax basis on the assets to which the power of appointment applied. If, under the terms of the husband’s trust, a third party, such as a special trustee who was someone other than the wife, had the right to grant the wife, before her death, such a power of appointment over selected trust assets such as the house and a fractional share of the apartment building, all of the house and a large portion of the apartment building would have a higher basis after the wife’s death. It should be possible to draft such a power of appointment that would be “general” for federal tax purposes but would not actually permit the redirection of the trust assets because the consent of a designated non-adverse party would be required to permit the power’s effective exercise. By requiring such a third party to consent to the exercise of the power of appointment, it would be, as a practical matter, difficult for the wife to redirect the assets to someone other than the children. The designated third party would probably want the trust instrument to indemnify the third party if he or she declines or agrees to go along with any exercise of the power of appointment by the wife. Such an “emasculated” general power of appointment can be used to obtain a higher basis for assets held in trust to reduce the income tax. The general power of appointment could be granted selectively to apply only to the assets with a higher basis, but not to the assets whose current basis is higher than their current fair market value.

If implemented in a timely manner, a basis harvesting provision could permit the heirs of most married couples to reap significant income tax savings.

 

For More About the Real Property, Trust And Estate Law Section

- This article is an abridged and edited version of one that originally appeared on page 54 of Probate & Property, September/October 2011 (25:5).

- For more information or to obtain a copy of the periodical in which the full article appears, please call the ABA Service Center at 800/285-2221.

- Website: www.americanbar.org/rpte.

- Periodicals: Probate & Property, bimonthly magazine; Real Property, Trust and Estate Law Journal, quarterly journal; and the e-Report, bimonthly electronic newsletter.

- CLE and Other Educational Programs: Watch out for RPTE’s monthly CLE teleconferences; for more information, please visit our website.

- Books and Other Recent Publications: The Advisor’s Guide to Life Insurance; The Commercial Lease Formbook, 2d. ed.; The Insured Stock Purchase Agreement, with Sample Forms, 2d ed.; From Handshake to Closing: The Role of the Commercial Real Estate Lawyer, 2d ed.; Education Planning: Taxes, Trusts, and Techniques; Real Estate Opinion Letter Practice; Green Building and Sustainable Development; A State-by-State Guide to Construction and Design Law, 2d ed.; The Law of Trustee Investments; An Estate Planner’s Guide to Life Insurance, 2d ed.; Foreclosure Law and Related Remedies, 2d ed., three chapter bundles now available; A Practical Guide to Commercial Real Estate Transactions, 2d ed.

 

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