Income tax is the new focus when drafting wills, trusts

Income taxes, some 20 years ago, had not been much of a consideration when devising a will or trust for estate planning purposes. The focus was on avoiding estate taxes. To that end, fundamental planning suggested that upon death sufficient assets be placed in a trust to utilize the decedent’s estate tax exemption, historically $600,000, to avoid estate tax on those assets, rather than pass them directly to a spouse.

“Most wills and trusts were drafted with this strategy in mind,” says John Schuman, Chief Planning Officer at Budros, Ruhlin & Roe, Inc.

“Now, because of significant increases in the estate tax exemption and the ability of a surviving spouse to utilize the exemption of a deceased spouse, known as ‘portability,’ those with less than $10 million in assets don’t need to create trusts with the intention of avoiding the estate tax,” he says. “The focus should be on taking advantage of the step-up in the income tax basis of those assets upon both spouses’ deaths. When an appreciated asset is received upon someone’s death, the asset’s income tax basis for the beneficiary is reset to the asset’s date of death value, which eliminates any income tax on the asset’s prior appreciation.”

Smart Business spoke with Schuman about crafting wills and revocable trusts with strategies for today’s estate-planning circumstances.

Why has a shift occurred in estate planning strategy?

Today, estate tax exemptions have increased to $5.43 million per person from $600,000 back in the 1990s. Additionally, portability allows a surviving spouse to inherit the unused exemption of their deceased spouse. This makes it possible for a couple to exclude $10.86 million in assets from the estate tax.

On the other hand, ordinary income tax rates have increased to 39.6 percent and capital gains rates have increased to 20 percent, plus a 3.8 percent surtax for high-income earners. Understanding that people with less than $10 million in assets have no estate tax concerns, the game has shifted to avoiding income taxes.

How is this change affecting estate-planning considerations?

Stepping up the income tax basis of assets upon death to eliminate gains for beneficiaries has become the new game in estate planning. Wills and trusts need to be reviewed so that an income tax basis step-up is possible on each spouse’s death.

Previously, people were encouraged to utilize their estate exemption to gift away assets in order to get the future appreciation of the asset out of their estate. Now, people should be encouraged to die with appreciating assets and utilize their estate exemption to get an income tax basis step-up.

Another strategy in this new game may be to move appreciating assets upstream to take advantage of a basis step-up. For example, a child could gift assets up to a parent so that when the assets come back down upon death the child gets a step-up in basis on those assets.

To whom does this apply and what assets are affected?

This is an opportunity for every couple likely to have less than $10 million in assets upon death. Those with more than that will still be concerned with the estate tax. However, this income tax planning is going to continue to grow in value because the estate exemption will be indexed with inflation. Assuming just 2 percent inflation, the estate exemption in 2025 could be as high as $6.6 million, and in 2035 as high as $8 million per person.

People who have business assets, depreciable assets such as real estate, or intellectual property and artwork, which are taxed at ordinary rates, should be particularly aware of this new planning strategy.

What measures are important to take now?

This is a paradigm shift in how to think about estate planning. While there is no sunset on the current estate tax law, it’s still possible that things could change. It is important to have flexibility within your wills and revocable trusts to allow beneficiaries to play either the estate or income tax game upon your death. Review your documents to ensure you’re planning for the right scenario.

Insights Wealth Management is brought to you by Budros, Ruhlin & Roe, Inc.