Estates Valued Over $5.7 Million Should Have A Cost-Basis Review

Learn Why Your Old Estate Plan Could Be Costing You Big in Capital Gains Taxes

Recently, many of the high net worth estate plans I’ve reviewed for clients with higher net worth have been outdated in costly ways. These are people with estates somewhere over $5.7 million. The most common reason is that they planned when the gift tax credit was lower and have not revisited the issue since then. If you have not had your will or trust looked at since 2010 you really should. Back when their “coupon” against estate taxes was a million dollars or less, they were told to divide assets and at the death of the first spouse, to have half of their stuff, or more, transferred to an Irrevocable Trust.

Worse still, many were told to make transfers to an Irrevocable Trust right away. I have even had people come to me after receiving this advice and acting on it in 2018, to protect property from a potential creditor, transfer the (highly appreciated) assets to the next generation – as in, deeding over valuable real estate to their kids. This was done without any capital gains tax analysis.

Unfortunately, this advice and these old Irrevocable Trusts, and many of the old Will-based estate plans that people still have will end up costing them much more in taxes. Why? Because the law changed. Also, because the advice they got, did not consider an analysis of cost basis.

Need Structure? Avoid Tax?

Another and separate criticism of many of these plans is that they provide no structure. What is structure? Let’s say you want some money set aside for the children of your first marriage when you die to ensure, they don’t get excluded when your spouse – their stepmother or stepfather, dies. Let’s also say that one of those children can’t manage money, and you want someone to look after him. Let’s also say that your other kid’s marriage is shaky, even though he doesn’t see it yet, and you want to make sure that his future ex-wife won’t get any of his inheritance. Or you want to make sure that the family camp stays in the family indefinitely. Those are all examples of “structure”.

With the estate plans I’ve been reviewing, for whatever reason, there was no discussion of a need for structure. Perhaps the family was much younger. Perhaps the sole focus was on defeating estate and gift taxes. Well, in my experience, to prevent family conflict, to preserve your estate from the many potential creditors and predators, you need to focus on both providing structure, and on avoiding taxes.

General Considerations for Estate Planning for Estates Over $5.7 million

As an estate planning attorney, I understand the complexity of planning for a large estate. In the first instance, the issues are the same as with more modest estates – providing structure. Protecting a surviving spouse, planning for continuity and management during a period of incapacity, providing structure for the next generation; remarriage protection, divorce protection, bankruptcy, lawsuit, substance abuse protection. Whether you have 300k or $32mm these are important issues to your family.

Let’s break it down

With estates over $5.7 million, there are additional issues. In addition to family and protection issues and providing structure, there are complex tax issues. As of the writing of this article, (2019), the estate tax credit in Maine is $5.7 million. That means that unless your estate is valued over $5.7 million, there won’t be an estate tax. The federal credit is $11.4 million per individual.  If you are a Maine resident, and you are over the $5.7 million, or you are an individual and you are over $11.4 million what can you do to reduce your taxes?

There are many things that can be done. But one of the most important first steps is to have a basis analysis of the assets in your estate.

Basis Planning

Because the lifetime gift estate tax exemption is very high, estate planning lawyers and the accountants they work with are focused on basis planning. Basis planning is analyzing the cost basis of assets in your estate. That information is used to determine if you can use the law to reduce the potential capital gains income tax upon the transfer or sale of those assets. Another useful product of a basis analysis is to determine if you can get a stream of income from those assets that is far more useful to you, than keeping an unproductive asset that you cannot sell without incurring a massive capital gains income tax. So, you may be able to increase your income, and avoid capital gains income taxes right now. Or save capital gains taxes for your next generation. Basis planning is very important because many estates are either not subject to the estate tax, or if they are subject to the Maine estate tax, the tax rate is much lower than the capital gains tax rate. That is why many of the old estate planning techniques could actually end up costing your estate more in taxes. And that is also why, if you have assets over $5.6 million and you have not had an estate plan review in a while, you should have one now.

Many of the plans I have reviewed have done nothing to provide structure, but also, would result in the payment of much more money in capital gains taxes to the heirs than in the estate and gift taxes they avoided. So, while these old plans will do what was intended, avoid estate and gift tax back when the credit was only $1million, they actually result in paying more in taxes – capital gains income taxes.

What kind of assets are we talking about with basis analysis?

We are talking about highly appreciated assets. Many people have securities. You know that Camden National Bank stock that grandpa gave you? How about that island in Penobscot Bay or the three acre plantation on Islesboro that your father bought in 1947? Fine art? Rental and investment real estate. In short, anything that the government will attribute a large gain to when it is sold. With the lifetime gift estate tax exemption at record levels, basis planning has become the single most important factor in reducing taxes for large estates.

What does cost basis estate planning look like?

The key to a well-constructed estate plan today is flexibility. We do many Revocable Living Trust estate plans. Revocable Living Trusts are flexible. You get to keep control over your assets, but a Revocable Living Trust also provides secure management of assets during a period of incapacity, and protection for a surviving spouse, and structure for the next generation. But what about basis planning in a Revocable Living Trust? The key is to allow for flexibility. The federal credit limit reverts to $6 million dollars in 2026. Congress may extend that. But Congress may also reduce the credit sooner than 2026. So we need to build flexibility into an estate plan. There is a way to give your estate the ability to choose whether or not to include property in your surviving spouse’s estate and still provide structure and protection. That’s like a toggle switch. If the gift tax credit is higher, we want estate inclusion, to get the step up in basis. If the estate tax credit is lower, or we’re over the limit we want to toggle some assets out of the estate. With a properly drafted Revocable Living Trust Plan, you can include assets in the estate of the first spouse to die, but also in the surviving spouse’s estate. Why would that be important? Because you could obtain two step-up in basis. That means that at the death of the first spouse, the value of that property is adjusted to the market value as of the date of death. And then again at the death of the second spouse, the value of the property is adjusted to the date of death value. By planning in that manner, you have saved your estate potentially hundreds of thousands if not millions of dollars depending on the appreciation of the asset.

Portability makes this planning even more attractive. Portability allows a surviving spouse to use any unused federal estate tax credit the deceased spouse did not use. That means that a married couple can use both of their federal estate tax credits and use estate inclusion to reduce capital gains taxes. This flexibility is particularly important for Maine residents. Because, if you die a resident of Maine the credit for estate and gift taxes is only $5.7 million (much less than the federal). But your surviving spouse may move. Or you both may move. You want to make sure that your estate plan can “move” with you. By building flexibility into a Revocable Living Trust plan, it won’t matter if you die a resident of Maine or Florida, you can still get a double step up in basis and avoid paying Maine estate and gift taxes. But that potential beneficial result requires some planning, that result does not happen automatically. And it certainly doesn’t happen with many of the old estate plans I’ve been reviewing lately.

Irrevocable Trust Plans

In these old plans that I’ve been reviewing, many are funded Irrevocable Trust-based. But they are not functioning with optimal tax efficiency. These Irrevocable Trusts require changes to avoid paying unnecessary taxes and even to build in some needed structure. But because an Irrevocable Trust is irrevocable changing it will always require some extra effort. An Irrevocable Trust may need to be decanted, or a power of appointment may need to be exercise, or some other legal method may need to be employed to get that trust property included in the estate. Why? Because if we can get it back into the estate at before death, we get the step up in basis. And now that the gift credit is so high, we don’t need or want the asset to be outside of the estate for estate tax purposes.

If you have the option to draft new documents, you can build in flexibility. There may be an opportunity to allow a Personal Representative, a Trustee or a Trust Protector to make tax elections or to take actions that would cause a property to be includable in the estate of a deceased person, and thus get the step up in basis. But if at the time of death, your estate doesn’t need inclusion or the estate tax situation has changed, that same Trustee or Personal Representative, or Trust Protector can decide to toggle the switch back to estate exclusion.

But what if your existing plan does not include these features? Then you need to know what your tax liability is. Once you determine that your estate is going to be subject to hundreds of thousands or possibly even millions of dollars in capital gains taxes after your death, you can decide how to fix that.

How can you change an Irrevocable Trust in order to fix a capital gains tax issue? Some of the methods of changing an Irrevocable Trust are to decant or change the situs to a jurisdiction that permits decanting or have the beneficiaries and trustee all sign off on a Court order permitting the change.

The point is, your old estate plan could be costing your estate a fortune in taxes.