Avoid a Tax Nightmare with your Trust

September 11, 2023

The other message is to be certain that the person serving as a trustee has the knowledge to administer the trust properly or the wisdom to retain an experienced estate planning attorney who will know how to administer a trust. Avoid a tax nightmare with your trust with the correct forms. Not every CPA has detailed knowledge about trust taxation, reports the recent article, “Trust’s Incorrect Tax Form Forfeited large Tax Refund Claim: A Lesson For Trustees,” from Forbes.

For income tax purposes, there are several types of trusts. “Grantor trusts” are those whose income is taxed to the person, the settlor, who created the trust. The trust at issue was a grantor trust. However, when the taxpayer who created the trust died, the trust became a non-grantor trust. These are also called “complex” trusts. The income is not reported by the person creating the trust. Complex trusts usually pay their own income taxes. The beneficiaries receiving distributions then report the income for tax purposes included in the income received from the trust. This is referred to as the trust’s Distributable Net Income or “DNI.”

In this case, the trust is the remainder trust after the termination of a Qualified Personal Residence Trust or “QPRT.” This is a trust used to transfer a valuable house from the taxpayer’s estate to descendants or to a trust for them at a discount from the trust’s current value.

The trust had income to report for income tax purposes, which will be done on Form 1041, U.S. Income Tax Return for Estates and Trusts. The trust felt it was entitled to a refund of some of the taxes it paid, so it filed for a refund. Refund claims are supposed to be filed by amending the trust income tax return, but the trust filed Form 843, a form to claim a refund. The wrong form led the Court to determine that the trust failed to take appropriate action, and the refund was lost. The trust’s filing did put the IRS on notice that the claim was the wrong action.

The IRS said the taxpayer’s filing of Form 843 was insufficient as a formal claim because an amended Form 1041 is the proper form. The Court found that the IRS is authorized to demand information in a particular form and to insist that the form is observed. The instructions on Form 853 advise that the form is for a refund of taxes other than income tax, while the instructions on Form 1041 indicate that it must be used to claim a refund.

What happened in this case? Someone managing the trust didn’t know enough about trust taxation. The family may not have had regular meetings with their estate and trust attorney who created the trust. The deceased taxpayer in this case was a judge, and the trustee was the son of the judge. The taxpayer died in 2015, and the house was sold for $1.8 million the next year. The IRS demanded $930,127 in taxes, penalties, and interest from the Trust. The Trust paid that amount assessed on September 24, 2021. The court opinion was handed down on August 7, 2023. The amount of costs in accounting and legal fees must have been enormous.

This is an excellent example of why families need to have regular, ongoing meetings with their estate planning attorneys and tax advisors to be sure everyone is on the same page. Annual reviews and an estate planning attorney focusing on trust taxation could avoid a tax nightmare with your trust. It would have saved this family money, time, and the stress of an unresolved IRS issue. If you would like to learn more about taxation in estate planning, please visit our previous posts.

Reference: Forbes (Aug. 19, 2023) “Trust’s Incorrect Tax Form Forfeited large Tax Refund Claim: A Lesson For Trustees”

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Cancelling Irrevocable Trust can cause Tax nightmare

September 5, 2023

Cancelling an irrevocable trust can cause a tax nightmare. For those in the high-income bracket, the potential tax consequences of canceling an irrevocable trust could be a major deterrent. And for those from middle-income backgrounds, the immediate financial impact, like the possible loss of income from the trust, the ramifications may be more, says Yahoo Finance’s recent article entitled, “Will Terminating an Irrevocable Trust Affect My Taxes?”

For example, if the trust holds significantly appreciated assets like real estate or vintage cars, the beneficiaries could face a large tax bill upon dissolution and may benefit from an alternative strategy. So, instead of dissolving the trust, it might be worth looking at ways to alter it better to fit the beneficiaries’ current needs and circumstances. This may include decanting—moving assets from one trust to another with more favorable terms— or moving the trust to a state with more favorable laws.

Income Taxes. An irrevocable trust may hold assets that generate income, including bank accounts, bonds, and dividend-paying stocks whose profits are taxed as ordinary income. Note that distributions from a trust’s principal aren’t subject to income taxes – only the gains. But if an irrevocable non-grantor trust is terminated, the income the assets have generated will presumably be distributed to the beneficiaries. It will be their responsibility to pay the taxes on the money. However, if the trust that’s dissolved is a grantor trust, the income tax liability will stay with the person who created the trust.

Capital Gains Taxes. Assets that appreciate within an irrevocable trust are subject to capital gains taxes. When these profits are realized and distributed at the termination of a trust, the beneficiaries will be required to pay the tax rate that corresponds with their income level.

Estate Taxes. When assets are transferred to an irrevocable trust, they’re removed from the grantor’s taxable estate, lowering the person’s potential estate tax liability when they die. Only large estates worth more than $12.92 million are subject to the federal estate tax in 2023, so it’s not an issue for most people. But in March 2023, the IRS announced that the step-up in basis doesn’t apply to assets held in irrevocable grantor trusts. For those assets to receive the step-up, they must be included in the grantor’s gross estate and be subjected to the federal estate tax. As a result, the termination of an irrevocable grantor trust could trigger the estate tax if assets return to their taxable estate.

Cancelling an irrevocable trust can cause a tax nightmare that may take years to resolve. Discuss your situation with your estate planning attorney for viable alternatives that may be less risky. If you would like to learn more about irrevocable trusts, please visit our previous posts.

Reference: Yahoo Finance (Aug. 13, 2021) “Will Terminating an Irrevocable Trust Affect My Taxes?”

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The IRS has issued a Ruling that will impact Grantor Trusts

July 18, 2023

The IRS has issued a ruling that will impact grantor trusts. Completed gifts to grantor trusts will not receive a Section 1014 step-up in basis upon the grantor’s death. According to the IRS, Revenue Ruling 2023-2 concludes this is the appropriate result because such property is not acquired from a decedent for purposes of Section 1014(a) of the IRC of 1986 as amended in Section 1014(b) of the Code, as reported by Reuters in the article “IRS confirms that completed gifts to grantor trusts are not eligible for Section 1014 step-up.”

Upon their death, assets received from a decedent are afforded a basis step-up under Code Section 1014. These are assets usually included in the taxable estate for estate tax purposes. However, before the Ruling, many practitioners wondered whether the assets of an irrevocable grantor trust would be eligible for the same benefit.

The irrevocable “grantor trust” is an anomaly under the Code. A “grantor trust” is not recognized as a separate taxpayer for income tax purposes during the lifetime of the creator (usually referred to as the “grantor” or the “settlor”). All income earned during the grantor’s lifetime is reported on the grantor’s individual income tax returns. However, if the grantor trust is irrevocable and if transfers to the trusts are deemed to be completed gifts, then when the grantor dies, the assets of the grantor trust are not included in the taxable estate of the grantor for estate tax purposes. Thus, the grantor trust is deemed to be owned by the grantor for income tax but not estate tax. This led to uncertainty over the eligibility of the grantor trust assets for the Code Section 1014 basis step-up on the grantor’s death.

“Intentionally defective” grantor trusts are widely used, where the grantor is treated as the owner of the grantor trust for income tax purposes and is responsible for paying the income taxes incurred by the trust. The payment by the grantor of the grantor trust’s income taxes effectively lets the grantor make additional tax-free gifts to the grantor trust and increases the grantor trust’s rate of return.

However, since the grantor trust is not a separate taxpayer for income tax purposes, there’s no recognition of gain on the sale or interest income on the note. The interest rate on the note can be the lowest rate which will not cause adverse tax consequences. If the interest sold to the grantor trust grows faster than the applicable interest rate, the excess growth passes, transfer-tax-free, to the grantor trust.

The “Sale Technique” has been used many times since the IRS released Revenue Ruling 83-15, supporting the position that a property sale from a grantor to a grantor trust is not a taxable event. If no gain is recognized on such a sale, the grantor trust takes a carryover basis in the grantor’s property.

With the release of Revenue Ruling 2023-2, how should estate planning attorneys advise their clients? There are a few strategies to consider:

Power to Exchange Assets. Many grantor trusts allow the grantor to substitute trust property for other assets of equivalent value. If a grantor trust has an asset with a low basis, during the grantor’s lifetime, they could exercise the Substitution Power to exchange the low-basis asset for property with a higher basis but of equal value. The low basis asset now becomes part of the grantor’s estate and, as long as the grantor retains it until their death, will be eligible for the Code Section 1014 basis step-up.

Second Sale to Trust. If the trust agreement establishing the grantor trust doesn’t grant Substitution Power, the grantor could purchase low-basis assets from the trust for high-basis assets. The grantor may engage in a series of sales to ensure appreciated stock continues to cycle back to the grantor, so the estate may take advantage of the Code Section 1014 basis step-up.

Granting a General Power of Appointment. In certain situations, it may be possible to grant a testamentary general power of appointment over a grantor trust to a parent or other elderly relative, the “Powerholder.” The grant of a general power of appointment results in the assets subject to such power being includable in the estate of the Powerholder for estate tax purposes. The trust assets in the Powerholder’s estate will then be eligible for the Code Section 1014 basis step-up upon the death of the Powerholder.

The grant of the general power of appointment should not exceed the Powerholder’s available estate tax exemption and only apply to assets with built-in gain. This strategy will require consideration of the Powerholder’s creditors and any possible risks to the grantor trust.

The IRS has issued a ruling that will impact grantor trusts. These are complex strategies requiring the help of an experienced estate planning attorney. If you would like to learn more about irrevocable grantor trusts, please visit our previous posts.

Reference: Reuters (June 21, 2023) “IRS confirms that completed gifts to grantor trusts are not eligible for Section 1014 step-up”

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LLCs can be a useful Tool in your Estate Planning

June 28, 2023

LLCs can be a useful tool in your estate planning. Limited liability companies, or LLCs, are used in estate planning to achieve estate tax savings and consolidate asset management, according to a recent article, “Estate Planning With Limited Liability Companies: Transfers of Business Interests as a Planning Opportunity,” from The National Law Review.

In many cases, the LLC is used as a business entity to facilitate gifting or transfers to children, often at discounted values, reducing the value of the donor’s assets, ultimately subject to gift and estate taxation. There are also non-tax benefits, as a properly structured LLC insulates owners from liability and provides an organizational control mechanism.

As a “manager-managed” entity, the management functions and authority over the LLC rests in designated or elected managers, as opposed to owners, also known as “members.” Separating management from ownership transfers some of the asset’s economic benefits, while retaining control over operations. Limiting managerial or voting rights also justifies using valuation discounts for the membership interests who lack control over the company, presenting a tax-planning opportunity.

An LLC offers several benefits:

A streamlined method of transferring ownership
Creating a structure for centralized management, control, and succession
Preserving family ownership through rights of purchase and first refusal
Establishing procedures to resolve internal family disputes
Gaining protection of LLC assets from claims asserted against owners
Gaining protection of owner assets from claims asserted against the LLC

Significant tax savings can be achieved through lifetime gifts of LLC interests because of valuation discounting and removing future appreciation from the donor’s estate. In addition, if transfers are made to trusts for the children, it may be possible to achieve even further benefits, including increased protection against lawsuits, dissolving marriages, and future estate taxes.

These are complex transactions requiring the knowledge of an experienced estate planning attorney and careful vetting by tax advisors. One downside to lifetime gifting: unlike assets passing as part of an estate, gifted assets do not receive a basis adjustment for income tax purposes at the time of the donor’s death. Another downside is that the donor generally cannot benefit economically from the assets after they are transferred. However, if the donor is concerned about divesting themselves of the transferred assets and the income, the transfer could be structured as a sale rather than a gift to provide increased cash flow back to the transferor.

A final note: if the LLC is not operated consistently with the entity’s non-tax business purposes, it may be vulnerable to attack by the IRS or third parties, undermining its benefits for estate tax planning and limited liability protection. The entity must be managed to support its valid business purpose as a legitimate enterprise. Remember, LLCs can be a useful tool for your estate planning, but only if it is properly created and maintained. If you would like to learn more about LLCs and business planning, please visit our previous posts.

Reference: The National Law Review (May 19, 2023) “Estate Planning With Limited Liability Companies: Transfers of Business Interests as a Planning Opportunity”

Pitfalls of Gifting and Joint Ownership

June 19, 2023

As with many things related to estate planning, do-it-yourself solutions appearing to be fast and easy fixes often become problems for parents and their children. Trying to simplify asset protection by gifting is loaded with risks, says a recent article, “SENIOR SCENE | Pitfalls of gifting and joint ownership of assets” from The Sentinel-Record. There can be many pitfalls of gifting and joint ownership.

Most notably, the laws governing eligibility for Medicaid used for nursing home care require a 60-month “look-back” period, where any transfer of assets for any reason makes the person ineligible for Medicaid benefits up to 60 months or even longer from the date the gift was made.

Secondly, creditors of the person making a gift could claim any transfer was a fraudulent transfer made in an attempt to defeat the rights of creditors to make a claim. Both parent and child could end up in costly, time-consuming litigation over creditor claims.

Third, and perhaps most problematic, is the chance for the child’s creditors to attach the assets in order to satisfy a claim against the child. This could also occur if the child is embroiled in a divorce—the assets could be considered a marital asset by the court.

Gifting assets was a popular estate planning strategy to reduce or eliminate estate taxes in the past. Nevertheless, in light of the very high current federal estate tax exemptions, this is only used for some families.

Another disadvantage of gifting is the transfer of tax cost basis from the parent to the child for capital gains tax purposes. As a result, the child would be forced to pay capital gains taxes on the increase in value from the parent’s tax cost—typically the original purchase price—versus the ultimate sales price.

Contrast this with a child who inherits an asset at death from a parent. When the child inherits the asset at death, the asset receives a step-up in tax basis to its date-of-death value. This is one of the most favorable tax rules remaining, which is lost when gifting during life is used.

Another problem occurs when seniors make assets jointly owned, especially bank accounts. The bank often encourages this, trying to be helpful so the child may pay the parents’ bills. However, by placing the child’s name on the account, the parent may be subjecting their account to potential creditor claims of their children.

In addition, the jointly owned account passes only to the surviving owner, so the estate plan may be circumvented by having the assets in the account pass to the one child rather than passing to all the remaining trust under a will or trust.

An estate plan created by an experienced estate planning attorney can eliminate many pitfalls of gifting and joint ownership. Before making gifts or establishing joint accounts, meet with an estate planning attorney to learn how to achieve your goals, including planning for Medicaid, without putting your assets at risk. If you would like to learn more about asset protection, please visit our previous posts.

Reference: The Sentinel-Record (May 28, 2023) “SENIOR SCENE | Pitfalls of gifting and joint ownership of assets”

Protecting Assets in a Second Marriage can be a challenge

May 23, 2023

Protecting assets in a second marriage can be a challenge. Parents in second marriages may want to leave assets to their children and try to make sure that their stepchildren don’t inherit. However, if stepchildren inherit, it can create resentment leading to legal disputes that can cost the estate significantly in delay and attorney fees.

AOL’s recent article, “How to Protect Assets From Stepchildren,” says that taking specific estate planning steps will let you effectively protect your assets from stepchildren.

If a stepchild inherits some of your assets, your children may feel cheated out of their rightful inheritance. Therefore, they may contest any awards to stepchildren to protect their interests.

Your children will be recognized as heirs to your estate even without a will naming them as beneficiaries. Stepchildren don’t have the same rights.

In most cases, they won’t inherit from a deceased stepparent’s estate unless specifically listed as beneficiaries in the will. However, stepchildren still may receive assets from your estate if your spouse dies after you and leaves assets to their children. Preventing stepchildren from ever getting assets from your estate can be done. However, it requires definite action to exclude them as beneficiaries.

If your spouse from a second or later marriage dies first, you usually don’t have to do anything to prevent stepchildren from receiving assets you control.

Even after an intestate death that happens without a valid will, stepchildren typically aren’t recognized as having any right to assets in the estate. However, some states grant stepchildren some rights of inheritance. Ask an experienced estate planning attorney about this.

In addition, a will can name specific people, including stepchildren, and exclude them from receiving benefits from the estate.

Using a trust, you can ALSO prevent stepchildren from getting assets from your estate after you die.

This can help avoid conflicts and potential litigation from children upset because stepchildren received assets from the estate.

Protecting assets in a second marriage can be a challenge. Remember that if you fail to act, stepchildren can still benefit even at the expense of your children if, for example, you die before your spouse, who then names their children as beneficiaries of the estate. If you would like to learn more about remarriage protection, please visit our previous posts.

Reference: AOL (April 26, 2023) “How to Protect Assets From Stepchildren”

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Protecting Assets with a Trust vs. LLC

May 10, 2023

While trusts and Limited Liability Companies (LLCs) are very different legal vehicles, they are both used by business owners to protect assets. Understanding their differences, strengths and weaknesses will help determine whether protecting assets with a trust vs a LLC is best for your situation, as explained by the article “Trust Vs. LLC 2023: What Is The Difference?” from Business Report.

A trust is a fiduciary agreement placing assets under the control of a third-party trustee to manage assets, so they may be managed and passed to beneficiaries. Trusts are commonly used when transferring family assets to avoid probate.

A family home could be placed in a trust to avoid estate taxes on the owner’s death, if the goal is to pass the home on to the children. The trustee manages the home as an asset until the transfer takes place.

There are several different types of trusts:

A revocable trust is controlled by the grantor, the person setting up the trust, as long as they are mentally competent. This flexibility allows the grantor to hold ownership interest, including real estate, in a separate vehicle without committing to the trust permanently.

The grantor cannot change an irrevocable trust, nor can the grantor be a trustee. Once the assets are placed in the irrevocable trust, the terms of the trust may not be changed, with extremely limited exceptions.

A testamentary trust is created after probate under the provisions of a last will and testament to protect business assets, rental property and other personal and business assets. Nevertheless, it only becomes active when the trust’s creator dies.

There are several roles in trusts. The grantor or settlor is the person who creates the trust. The trustee is the person who manages the assets in the trust and is in charge of any distribution. A successor trustee is a backup to the original trustee who manages assets, if the original trustee dies or becomes incapacitated. Finally, the beneficiaries are the people who receive assets when the terms of the trust are satisfied.

An LLC is a business entity commonly used for personal asset protection and business purposes. A multi-or single-member LLC could be created to own your home or business, to separate your personal property and business property, reduce potential legal liability and achieve a simplified management structure with liability protection.

The most significant advantage of a trust is avoiding the time-consuming process of probate, so beneficiaries may receive their inheritance faster. Assets in a trust may also prevent or reduce estate taxes. Trusts also keep your assets and filing documents private. Unlike a will, which becomes part of the public record and is available for anyone who asks, trust documents remain private.

LLCs and trusts are created on the state level. While LLCs are business entities designed for actively run businesses, trusts are essentially pass-through entities for inheritances and to pass dividends directly to beneficiaries while retaining control.

Your estate planning attorney will be able to judge whether protecting your assets with a trust vs an LLC is the best option for you. If you own a small business, it may already be an LLC. However, there are likely other asset protection vehicles your estate planning attorney can discuss with you. If you would like to learn more about business planning, please visit our previous posts.

Reference: Business Report (April 14, 2023) “Trust Vs. LLC 2023: What Is The Difference?”

Revocable Trusts Must Be Funded to be Effective

May 3, 2023

Revocable assets simplify asset management during life and facilitate private asset transfers at death. Therefore, you might think your estate planning is done when you sign the revocable trust agreement. Nevertheless, it’s not done until you fund the trust, advises a recent article, “’It Ain’t Over ‘Til It’s Over’ – Use of a Funded Revocable Trust in Estate Planning” from The National Law Review. Remember, revocable trusts must be funded to be effective.

A trust is a legal agreement allowing one person—the trustee—to hold and manage property to benefit one or more beneficiaries. The person who creates the trust—the grantor—can create a trust during their lifetime and modify or terminate the agreement at any time. The grantor is the initial trustee and the initial beneficiary. These dual roles allow the grantor to control the trust assets during their lifetime.

Upon death, the revocable trust becomes irrevocable. The trust agreement directs the distribution of assets and appoints the trustee to manage and distribute assets. Unlike a will, the revocable trust works during your lifetime to hold assets.

Funding the trust is critical for it to perform. Assets must be transferred, with an asset-by-asset review conducted to determine which assets should go into the trust. The assets should then be transferred—usually by title or deed changes—which your estate planning attorney can help with.

A funded revocable trust avoids having the assets go through probate. State statutes and regulations require several steps to be completed, adding time, effort and cost to estate administration. Suppose that the revocable trust at death owns the assets. In that case, the trust owns the legal title to the assets, and assets can be distributed to beneficiaries without court intervention.

Avoiding probate also reduces expenses. The expense of probate administration arises from two sources: probate fees and attorney fees. These vary by state and jurisdiction. However, they can add up quickly. A funded revocable trust minimizes both types of fees.

Unlike the will, which becomes a public document once it goes through probate, revocable trust assets and beneficiaries remain confidential, known only to the trustee and beneficiaries. Anyone who wants to can request and review your will and obtain information about assets and beneficiaries. However, the trust is a private document, protecting your loved ones from scammers, overly aggressive salespeople, and nosy relatives.

Privacy can be essential for business owners. For example, suppose you die owning a business interest as an individual. In that case, the description and value of business interests must be reported on the public record during the probate process and is available to potential purchasers to use as leverage against your estate. Transferring business interests to a revocable trust during your lifetime can keep that information private.

Trusts are also used for asset protection for assets with beneficiary designations, including life insurance, IRAs and retirement plans. For instance, if a life insurance policy is paid to your estate, creditors of your estate may have access to the proceeds. If it is paid to the trust, it is protected from creditors. A Revocable trust is only as good as its funding. Revocable trusts must be funded to be effective. If you would like to learn more about RLTs, please visit our previous posts.

Reference: The National Law Review (March 3, 2023) “’It Ain’t Over ‘Til It’s Over’ – Use of a Funded Revocable Trust in Estate Planning”

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Life Estate can be a Cost Effective Option

April 27, 2023

A life estate can be a cost effective option for couples. The person who holds the life estate is known as the life tenant. He or she is entitled to live in and use the properly as they see fit. However, they don’t have the right to sell or transfer the property to someone else.

Realty Biz News’ recent article entitled, “What is a Life Estate and How to Use It,” explains that a recorded deed will reference that a property is a life estate and name the life tenant. Once the life tenant passes away, the property passes to the remainderman—those who will inherit the property after the life estate ends. Let’s look at some of the reasons why someone might want to have a life estate:

Estate Planning. By transferring property into a life estate, the original owner can ensure that the property will pass to a designated beneficiary without probate. It can be particularly useful for people who want to avoid the time, expense and complexity or the probate process.

Asset Protection. The original owner can protect the property from creditors and other potential liabilities by transferring the property into a life estate. This is useful for those in high-risk professions or with significant debts or legal issues.

Family Dynamics. A life estate can also be used to address family dynamics and ensure that everyone is taken care of. For example, a parent might create a life estate to ensure that their adult child can live in the family home for the remainder of their life without giving them outright ownership of the property.

Tax Planning. By transferring property into a life estate, the original owner can reduce their taxable estate and potentially lower their estate tax liability. This can benefit individuals with large estates who want to minimize their heirs’ tax burden.

When a life estate is created, the property is divided into two parts:

the life estate; and
the remainder interest.

The life tenant has the right to use and enjoy the property during their lifetime. The remainderman has the right to inherit the property after the life estate ends.

Remember, with a life estate; the ownership is broken down into possession and ownership. The life tenant has possession and ownership until they pass away; the remainderman has ownership only. When the life tenant passes away, the property passes to the remainderman, who becomes the new owner. The remainderman has the right to sell, transfer, or otherwise dispose of the property as they see fit. Speak with your estate planning attorney to see if a life estate can be a cost effective option for your family’s planning. If you would like to learn more about life estates, please visit our previous posts.

Reference: Realty Biz News (March 20, 2023) “What is a Life Estate and How to Use It”

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Step-Up in Basis can help Avoid or Reduce Taxes

April 25, 2023

Step-up in basis, also known as stepped-up basis, is a wrinkle in the federal tax code that can help heirs avoid or reduce taxes on inherited assets. This aspect of the tax code changes the value—known as the “cost basis”—of an inherited asset, including stocks or property. As a result, the heir may receive a reduction in the capital gains tax they must pay on the inherited assets. For others, according to the recent article, “What Is Step-Up In Basis?” from Forbes, it allows families to avoid paying what would be a normal share in capital gains taxes by passing assets across generations. Estate planning attorneys often incorporate this into estate plans for their clients to minimize taxes and protect assets.

Here’s how it works.

If someone sells an inherited asset, a step-up in basis may protect them from higher capital gains taxes. A capital gains tax occurs when an asset is sold for more than it originally cost. A step-up in basis considers the asset’s fair market value when it was inherited versus when it was first acquired. This means there has been a “step-up” from the original value to the current market value.

Assets held for generations and passed from original owners to heirs are never subject to capital gains taxes, if the assets are never sold. However, if the heir decides to sell the asset, any tax is assessed on the new value, meaning only the appreciation after the asset had been inherited would face capital gains tax.

For example, Michael buys 200 shares of ABC Company stock at $50 a share. Jasmine inherits the stock after Michael’s death. The stock’s price is valued at $70 a share by then. When Jasmine decides to sell the shares five years after inheriting them, the stock is valued at $90 a share.

Without the step-up in basis, Jasmine would have to pay capital gains taxes on the $40 per share difference between the price originally paid for the stock ($50) and the sale price of $90 per share.

Other assets falling under the step-up provision include artwork, collectibles, bank accounts, businesses, stocks, bonds, investment accounts, real estate and personal property. Assets not affected by the step-up rule are retirement accounts, including 401(k)s, IRAs, pensions and most assets in irrevocable trusts.

If someone gives a gift during their lifetime, the recipient retains the basis of the person who made the gift—known as “carryover basis.” Under this basis, capital gains on a gifted asset are calculated using the asset’s purchase price.

Say Michael gave Jasmine five shares of ABC Company stock when it was priced at $75 a share. The carryover basis is $375 for all five stocks. Then Jasmine decides to sell the five shares of stock for $150 each, for $750. According to the carryover basis, Jasmine would have a taxable gain of $375 ($750 in sale proceeds subtracted by the $375 carryover basis = $375).

The gift giver is usually responsible for any gift tax owed. The tax liability starts when the gift amount exceeds the annual exclusion allowed by the IRS. For example, if Michael made the gift in 2018, he could avoid gift taxes on a gift he gave to Jasmine that year with a value of up to $15,000. This gift tax exemption for 2023 is $17,000. Talk with your estate planning attorney to see if a step-up in basis can help avoid or reduce taxes. If you would like to learn more about tax planning, please visit our previous posts.

Reference: Forbes (March 28, 2023) “What Is Step-Up In Basis?”

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Category: Asset Protection

Avoid a Tax Nightmare with your Trust

Cancelling Irrevocable Trust can cause Tax nightmare

The IRS has issued a Ruling that will impact Grantor Trusts

LLCs can be a useful Tool in your Estate Planning

Pitfalls of Gifting and Joint Ownership

Protecting Assets in a Second Marriage can be a challenge

Protecting Assets with a Trust vs. LLC

Revocable Trusts Must Be Funded to be Effective

Life Estate can be a Cost Effective Option

Step-Up in Basis can help Avoid or Reduce Taxes

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