Income Tax Cost Basis Planning


Prior to the recent and significant increases in the federal estate tax exemption amount, many clients engaged in planning the purpose of which was to ensure the use of both spouses’ exemption amount through the use of a “bypass” or “credit shelter” trust at the first death and/or excluding assets from one’s taxable estate through the use of irrevocable trusts. A byproduct of this planning, however, was the loss of a basis step up for income tax purposes when a surviving spouse died. That is, the general rule that basis of an asset is stepped up to its fair market value at the date of death is not the case for assets held in bypass, credit shelter and irrevocable trusts because such assets are not part of the surviving spouse’s estate.


For example, if one spouse owns real estate worth $500,000 at that spouse’s date of death, and the real estate ends up in a bypass trust in order to keep it out of the surviving spouse’s estate, and at the second death the real estate is worth $2,000,000, then there will be a $1,500,000 capital gain that would be taxed when the real estate is sold. Assuming a federal income tax rate of 20%, the 3.8% Medicare surtax on investment earnings, and a Pennsylvania income tax of 3.07%, the tax would be approximately $403,050 (this example does not account for any depreciation recapture, which would increase the tax liability).


Among other things, the American Taxpayer Relief Act of 2012 established the estate tax exemption amount at $5,000,000 per person, with this amount increasing annually based on inflation. For 2013, the exemption amount is $5,250,000 per person. The significant increase in the estate tax exemption amount is illustrated by the fact that the exemption amount was as low as $600,000 in 1997. Consequently, there are clients who no longer have exposure to the federal estate tax even with the inclusion of the value of assets previously gifted or which funded a trust when the first spouse dies. However, these clients – given the structure of their estate plan – cannot achieve a basis step up at death.


With respect to existing bypass, credit shelter and irrevocable trusts, some clients would like to “unring the bell” with regard to prior planning, but this is not always possible. Although an irrevocable trust can be terminated in certain circumstances, the termination of the trust will require the consent of all beneficiaries and the fiduciary obligations of the trustee may make termination difficult if not impossible. In addition, the termination of a trust will eliminate the creditor protection offered by the trust, which may be ill-advised if the surviving spouse anticipates long-term care expenses. Likewise, a family limited partnership may be unwound, but the distribution of the property owned by the partnership may have adverse tax consequences and, like a trust, the creditor protection afforded by the limited partnership will be lost. Many clients think of creditors in the context of lawsuits, but potential creditors would include long-term care providers and, in certain circumstances, the Pennsylvania Department of Public Welfare.


What can be done to amend an estate plan to provide for a basis step up? There are several options that can be considered depending on your situation.

  • For clients that have established a family limited partnership, the client could take the position that an implied agreement existed among the partners so that the partnership was, for estate tax purposes, a sham. Therefore the partnership assets are part of the decedent’s estate. The risk of this strategy is that creditors may be able to disregard the partnership as well.
  • For clients who have established a “qualified personal residence trust,” the client could argue that an implied agreement exists whereby the clients would continue to use and enjoy the residence after the trust terminates (for example, by staying at the property without paying rent). This strategy can be particularly attractive for shore properties in New Jersey and Delaware since New Jersey’s inheritance tax does not apply to transfers to children and Delaware’s estate tax provides for an exemption equal to the federal estate tax exemption.
  • For clients who established irrevocable trusts during their lifetimes, the trust agreement could be amended to give a third party, such as the trustee, the discretion to grant the client a “limited power of appointment.” The limited power of appointment provides the client with the right to shift the benefits of the trust among the beneficiaries, and results in the inclusion of the trust’s assets in the client’s taxable estate, even if not exercised. The risk with this strategy is that the third party must actually grant the client the limited power of appointment prior to the client’s death.
  • A trust agreement may be amended to grant the beneficiary (such as a surviving spouse) a “general power of appointment.” A general power of appointment allows the beneficiary upon his or her death to direct the trust assets to any person or entity and therefore results in the inclusion of the trust assets in the beneficiary’s estate. This strategy presents the problem that the beneficiary may direct the trust assets outside the family and also presents creditor protection issues. The trust agreement could also be amended to give the third party the discretion to grant the general power of appointment to the beneficiary (although this presents the same timing issues as the limited power of appointment strategy outlined above).

Those clients that desire estate inclusion will have to pay the Pennsylvania inheritance tax if it applies. The tax rate is 4.5% for transfers to children and other descendants. Using the example above, the tax on $2,000,000 transferred to children is $90,000 (a tax savings of $313,050).


Each client’s situation is unique, and caution should be exercised in employing any strategy to gain a basis step up. Generally speaking, implementing a basis step up strategy could upset a decedent’s estate plan or create an opportunity for a creditor to recover assets that were otherwise creditor protected. Nonetheless, the trading of an inheritance tax for the basis step up may be worth the potential risks.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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