Taxes and gifting, estate planning makes a huge difference

Estate Planning: Income Tax Strategies

            Law firms have had to take a spike in income tax rates, a decline in the estate tax rate, and an increasing annual estate tax exemption threshold into account in devising estate planning strategies. There has been a decreasing gap between the income tax rates and estate tax rates: estate tax has moved to a maximum rate of 40% and a $5.45 million exclusion in 2016, from a 55% percent tax rate and a $675,000 exclusion in 2001; the maximum tax rate on ordinary income is 39.6%, up from a low of 35 percent in 2003; the maximum long-term capital gains tax rate increased to 20% from 15% in that same time frame. Furthermore, in 2013 an additional 3.8% surtax was added for net investment of individuals, estates, and trusts over statutory threshold amounts in certain cases. While these numbers might make you think that estate planning is only necessary for the super wealthy, financial planners advise that it is not. Taxes are just one consideration of estate planning: it is critical to plan for an orderly transfer of assets or for other circumstances such as incapacitation.

The capital gains tax rate – the long-term rate of 20% plus the 3.8% surtax – is significant because it affects the basis of assets. When a decedent dies, her beneficiaries get the benefit of a step-up in basis, which is appreciated assets held in the decedent’s estate are readjusted to fair market value at the time of inheritance. Through this mechanism, the beneficiary receives an income tax advantage because she is not liable for the capital gains tax on any appreciation that occurs up to the point she inherits the asset.

So those estates subject to the tax, the issue becomes whether to make gifts in estate planning, or should they hold onto the property. If it is an asset that has a high basis, or little appreciated value, then it is more beneficial to make a lifetime gift. By making a lifetime gift, the donor avoids estate tax on the asset because the asset is removed from the estate, and the carryover basis takes the high basis and puts it in the recipient’s possession. Additionally, because the asset does not gain much appreciated value, when the beneficiary is ready to sell, she will likely recognize a lower tax on the capital gain. If it is an asset that has a low basis, the person may want to hold onto the asset until death in order to get the step-up in basis and prevent the beneficiaries from having to pay a high capital gains tax.

There are other tips that can be taken into account in order to reduce the impact of income tax on estate planning. Some of these options include investing in municipal bonds to generate tax-free income, contributing to a retirement plan or IRA, funding a flexible spending account, or deferring compensation income which can reduce adjusted gross income and prevent a taxpayer from reaching key income thresholds that may result in a higher tax bill. Another consideration might be for younger investors or taxpayers in lower tax brackets to use Roth accounts to create a source of tax free income in retirement. Roth income is not subject to the new 3.8% surtax and is also not included in the calculation for the $200,000 income threshold to determine if the new surtax applies. Lastly, it is always a good idea to consult with an attorney to see if more complex wealth transfer techniques may be appropriate because especially for those with non-liquid assets such as real estate or closely held businesses. Examples of these complex strategies include grantor trusts, family limited partnerships, and dynasty trusts where available.

This article is meant to give a brief understanding of income tax strategies in the context of estate planning. Those interested in more information on this topic should consult an attorney. Please do not hesitate to contact the attorneys of Chepenik Trushin LLP, who are ready, willing, and able to assist with your estate planning and probate litigation needs.


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