Estate Planning and the Capital Gain TaxEstate Planning and the Capital Gain Tax

Back in the heyday of estate planning when just about everyone who died owning a home and an IRA would have an estate subject to this tax, the choice between paying estate tax versus paying capital gain tax was an easy one to make. Up until the last few years, the highest estate tax bracket was 55% and the top long-term capital gain tax bracket was only 15%. If you had a choice of paying the estate tax or paying the capital gain tax, the capital gain tax was the obvious choice.

This choice was really so clear-cut that most of you reading this probably had no idea there was such a choice to make. The estate tax and capital gain tax are entirely different taxes and apply at entirely different times. How could these taxes in any way be related, especially to the point where payment of one may affect payment of the other?

Whether you realized it or not, when your attorney set up your estate plan, he made the choice for you: minimize estate tax even if the estate tax planning could cause an increase in capital gain taxes. With a rate differential of as much as 55% versus 15%, the attorney could rarely be faulted for optimizing the estate tax savings over capital gain tax savings.

To understand how this tradeoff works, you need to understand why estate and capital gain taxes are related.

Deep in the recesses of that wonder of legislative ingenuity called the Internal Revenue Code lies Section 1014. The gist of this section is this: when a person dies, any assets which are owned by that person at death receive a tax basis equal to the value of the asset on the person’s date of death. So very simply, if at your death you own one share of IBM stock valued on the day you died at the price of $100, and if you happened to have purchased that share for only $75, then the person lucky enough to survive you and inherit that one share is entitled to a “basis” in the stock of $100, even though your basis on the day before you died was the $75 you paid for that share. Thus, the capital gain of $25 that accrued from the date you bought the stock until the day you died is forgiven and when your heir sells the stock, he pays gain only on the amount by which the stock value exceeds his $100 basis. (This rule does not apply to all assets. For example, an inherited IRA enjoys no such forgiveness of gain and the heir of the IRA must recognize ordinary income for the value of any distributions received from an IRA.)

So, you may ask yourself, what does this have to do with the tradeoff between estate taxes and capital gain taxes? Let’s say that back in the days when the top estate tax rate was 55% and the top long-term capital gain tax rate was 15% your estate planning attorney suggested to you that you take advantage of something we call the gift tax annual exclusion, a generous dispensation from our betters in Washington D.C., which allows each of us, if we feel we can afford it, to each year make gifts of up to $14,000 in value to each of as many people as we wish without incurring any tax on making the gift. Therefore, if you were to write a check to each of your, let’s say three children and two grandchildren for $14,000 each year (a total of $70,000 in gifts) you would not be required to report the gifts, nor would you incur any gift tax on making such gifts. So what estate planning attorneys did back in that golden era is this: we set up gifting programs where the client, aware of his mortality, would take advantage of this tax-free gifting opportunity and make gifts every year to the objects of his bounty, usually his descendants, with the hope that by making these gifts the value of his estate would be reduced, thereby reducing the expected estate tax on his death.

But a funny thing happened to many of us on the way to our eternal reward: the law was changed. First to change was the increase in the overall estate tax exemption which increased from $60,000 in 1981, to $600,000 in 1987, and then to $1,000,00 (as best as I can recall) in year 2000, and which is now, for persons who die in 2014, a full $5.034 million. Furthermore, the top estate tax rate has dropped from 55% to 40%. The result of all this is that there are very few of us who are even subject to this tax now, especially since, if you are married and your spouse dies, you may inherit his or her $5.034 million estate tax exemption, leaving you with an exemption of a full $10.068 million! Over the course of a few years, all this planning we estate planning attorneys helped our clients implement has been rendered, for many, unnecessary because most of our clients’ estates, even without the gifting programs, would still be less than $10 million.

So you may say “no harm no foul.” What difference does it make? Most people do not mind having made the gifts and are still grateful to their vigilant estate attorney for the planning which may have been used to help the children out, teach them responsibility, or any other benefit we can use to help us feel good about the process.

But here is the problem. If those assets you transferred to your children, or to trusts for their benefit, have appreciated in value from the date of the gift, the tax law provides that the children do not get an adjusted basis in those assets on your death; rather, their tax basis will be equal to your tax basis, generally what you paid for the asset, and the forgiveness of capital gain, which was described above with the respect to the one share of IBM, will not occur at your death, leaving the heirs with a potential for a much larger capital gain taxes because any gifted assets are not included in the donor’s estate, and, therefore, do not get the basis adjustment allowed under Section 1014.

As a result of this kind of planning, there are many gifted assets out there which, had they not been gifted, were (or will) never be subject to the estate tax due to the $5+ million estate tax exemption, but will now be subject to capital gain tax when the heir sells the asset.

If you made gifts like these into a trust, certain trusts may allow the tax-free swap of low-basis, high-value assets from the trust with your own high-basis, high-value assets, such as cash. The result of these swaps is to get the assets back to the older parents so that when the parent dies, the low-basis, high-value assets will be part of the estate of the parent and will get the basis increase as allowed under Internal Revenue Code Section 1014.

Here is another problem: the typical planning between husband and wife for the past thirty years has been to create what are called “A-B trusts”, or “A-B-C trusts”, or “bypass trusts” or “credit shelter trusts.” Regardless of the name, these trusts made total sense when they were established because such trusts were designed to maximize the estate exemption available between husband and wife by preserving the exemption of the first spouse to die. These types of trusts have saved billions, probably trillions, of dollars in estate taxes, and they had their day, but for persons whose estates are less than $5 million and likely to stay on the lower side of $5 million, these trusts may no longer be necessary. However, many, if not most, husbands and wives who have these types of trusts have not updated their estate plans in the past ten years and it is likely for many of them that when one dies, even though the estate split to the “credit shelter trust” is possibly no longer necessary, the trust document requires the split to occur, with the result that the assets held in the credit shelter trust, upon the death of the second spouse to die, will not be considered assets of the spouse’s estate, will not receive the basis adjustment as allowed under Section 1014, and will, as a result, not be entitled to the forgiveness of the capital gain tax which would otherwise result had the asset not been split, unnecessarily, into the creditor shelter trust upon the death of the first spouse to die. This is not to say that this type of planning is no longer advisable, but merely to suggest that each client must be aware of the impact of these types of trust and make an informed decision.

Avoiding the capital gain tax is more important than ever. Not only has the rate increased to 20%, but there is an Affordable Care Act surtax of 3.8% on capital gains in excess of a certain minimum.

What should you do? I will give you one guess. You’re right: talk to an estate planning attorney to evaluate your risks on these matters and formulate a plan to minimize the overall impact of both the estate and capital gain taxes. (We can even help sometimes with income taxes, believe it or not.) If you are married and if you and your spouse have trusts which leave everything to each other first, and then, after the second one of you dies the estate passes to your heirs, if your trust does not require a split of your estate into two or three trusts at your death, but merely allows the surviving spouse to do something called a disclaimer, you probably have a plan that will give the maximum flexibility to the surviving spouse, so nothing more may be necessary. Nevertheless, a periodic review of your plan is always a good idea.

Of course, if you do happen to have an estate that exceeds $5 million, or an estate that when combined with your spouse’s estate exceeds $10 million, the mandatory split of the trust at the first death is still probably a good idea, but a review can give you the opportunity to make sure your planning is optimal.

All these changes in the tax law over the past few years have created many opportunities for planning. But as a result of the tradeoff between estate tax and capital gains tax which has been affected by these recent changes, the planning process has, in many ways, become more complex. Plans which have not been examined since January of 2013 are probably due for a checkup.

David M. Grant