To transfer your wealth in the most cost-effective manner, it’s important to understand how an asset’s income tax basis affects your estate planning strategies. The basis that your beneficiary receives in an asset depends on how you transfer it, and this can have a large impact on the recipient’s income tax bill.
What is basis?
Essentially, basis is the cost associated with an asset. It’s used to measure your gain or loss when you dispose of the asset and, if the asset is used in your business, it’s used to determine the amount of depreciation, depletion or amortization deductions.
When you sell an asset, your gain or loss is determined by taking the sale proceeds and subtracting your adjusted basis. So, for example, if you purchase stock for $100,000 and sell it for $150,000, you’ll recognize a $50,000 gain. On the other hand, if you sell the stock for $75,000, you’ll have a $25,000 loss.
The starting point for calculating an asset’s basis is the price you pay for it (including the amount of any existing debt you agree to assume in connection with the purchase). But depending on the nature of the asset, your basis may be adjusted to reflect changes that increase or decrease your investment in the asset.
Suppose, for example, that you purchase stock in an S corporation. Your initial basis is the price of the stock plus the adjusted basis of any property you contribute to the corporation.
Over time, your basis is increased by your taxable share of the corporation’s income, as well as by additional capital contributions or loans you make to the corporation. (Be aware that your basis isn’t increased by the fact that you guarantee a loan made by the corporation.) Your basis is decreased by items such as your share of distributions and any tax losses that are passed through to you.
Your basis in an asset has significant tax implications, so it’s important to track basis carefully and to document any events that increase or decrease it.
Why does basis matter?
From an estate planning perspective, basis is important because it affects the amount of taxable gain your beneficiary will recognize should he or she sell the asset. And your beneficiary’s basis in an asset depends on the manner in which you transfer it.
The general rule is that, when you transfer an asset at death, your beneficiary receives a “stepped-up” basis equal to the asset’s fair market value on that date. If you transfer an asset by gift, however, your adjusted basis in the asset “carries over” to your beneficiary.
At first glance, it would seem that transfers at death are preferable because a stepped-up basis minimizes the gain on a sale of the asset. But it’s not that simple. To determine the best strategy for transferring assets you need to look at the big picture.
First, consider your basis in an asset. If the asset’s value hasn’t appreciated significantly — so that its fair market value isn’t substantially higher than your basis — then the manner in which you transfer the asset won’t have a big tax impact on your beneficiary. Also, if your beneficiary plans to hold onto the asset rather than sell it, the income tax implications may not be a significant factor.
Case in point …
It’s important to balance any negative income tax consequences against potential transfer tax savings. For example, Todd, whose net worth is well above the $3.5 million estate tax exemption, wants to transfer $1 million in publicly traded stock to his daughter, Rebecca. Todd’s adjusted basis in the stock is $200,000, and he’s already used up his $1 million lifetime gift tax exemption.
If Todd gives the stock to Rebecca, he’ll owe $450,000 in gift tax (assuming a 45% rate). His basis carries over to Rebecca, and she also gets to increase her basis by virtue of the fact that he paid gift tax.
The increase is determined by a formula of the gift tax paid and the appreciation gifted. In this instance, she increases the basis by 80% of the $450,000 gift tax paid. Thus, her adjusted basis is $560,000. So if she sells the stock she’ll recognize a $440,000 gain, resulting in a $66,000 federal capital gains tax liability (at the current rate of 15%). (For illustrative purposes, it’s presumed that Rebecca lives in a state that has no income tax.) The combined tax on the transfer (assuming Rebecca sells the stock immediately) would be $516,000.
It seems that a transfer of the stock at Todd’s death is preferable because Rebecca would receive a stepped-up basis and avoid the $440,000 gain. That would be true if Todd were to die tomorrow. But what if he dies 10 years later and the stock’s value grows to $2 million? Rebecca wouldn’t inherit any built-in capital gains, but Todd’s estate would owe $900,000 in estate tax (assuming no change in the estate tax rate).
As you can see, determining the best strategy can be a challenge. Are Todd and his family better off paying $516,000 in taxes now or $900,000 in 10 years? Will the stock’s value actually double in 10 years? The answers depend on the time value of money and Todd’s best guess of the stock’s performance and value in the future.
Bear in mind that, if Todd had not previously used his lifetime gift exemption, there would be no gift tax paid on the gift and, consequently, no adjusted basis for Rebecca. If she were to sell the asset immediately, her gain would be $800,000, and she’d owe a capital gains tax of $120,000.
What does the future hold?
Complicating matters further, as of this writing current law calls for the estate tax to be repealed in 2010 and to be reinstated in 2011. During 2010 only, assets transferred at death won’t be entitled to a stepped-up basis, except for a limited amount of property.
It’s likely that Congress will pass legislation this year that preserves the estate tax, but it’s not yet clear whether such legislation will modify the basis rules. So it’s important to keep track of your income tax basis in various assets and to evaluate its potential impact on your estate plan.