For the past several years, estate planners have been in a bit of a tizzy. Starting with the gradual increase in the estate and gift tax exemption amounts during the second Bush administration and continuing in more recent years when lawmakers made permanent the portability provisions for spouse's to inherit unused lifetime gift and estate tax exemptions from their partners, fewer clients actually require estate tax planning. Currently, a married couple's estate is exempt from federal taxes up to roughly $10.5 million. There’s only a limited number of couples who exceed that lofty threshold, so where are estate planners to drum up business if not from the old faithful well of estate tax planning?
One of the answers that the estate-planning community has come to is a renewed focus on income tax. “Basis” has become one of the new buzzwords for estate planning practitioners.
Paul Lee, with Northern Trust's Wealth Advisory Services Group, recently spoke at the 50th annual Heckerling Institute on Estate Planning in Orlando, Fla. He has long espoused income tax basis planning in lieu of traditional estate tax planning. Truly new ideas are pretty rare in the estate-planning world, and this one is worth revisiting.
The rationale behind this thinking is that traditional estate tax planning entails aggressively transferring assets out of an estate to get the estate below the estate tax exemption level, but in doing so sacrificing the step up in the cost basis on those assets that would result if they held them until the estate transfer. That strategy works best when there’s a big gap between the respective rates for estate/transfer and income taxes, making focusing on limiting the estate tax, while taking the tax hit on the sale of assets at the original cost basis, a worthwhile strategy. But now, the high exemptions, enactment of the American Tapayer Relief Act of 2012 (ATRA) and imposition of the 3.8 percent medicare surtax have narrowed that gap.
For many high-net-worth individuals, it may no longer be worth sacrificing the future income tax benefits of getting the step up in cost basis. In fact, for some clients, the rising exemptions and decreasing transfer tax liabilities have created a situation where leaving certain assets in an estate just to get the step up at death effectively has no penalty anymore. Lee jokingly refers to this set of circumstances as “free-basing,” and encourages planners to consider filling their client’s exempt estates with appropriate assets that have a low cost basis and a high fair market value, in order for heirs to reap the income tax benefits later.
For some financial advisors and income tax planners, these techniques are old hat. They’re no strangers to strategically paying tax on certain items and “filling brackets” to shave a few percentage points off the eventual tax bill down the line, activities akin to this sort of basis planning. However, estate planners have focused on the estate tax and the mantra of getting everything out of the taxable estate for so long that change of this magnitude (effectively encouraging them to do the opposite) can penetrate the industry very slowly. Estate planners may focus on wealth transfer strategies with a scope in decades, if not generations; but the world, and the rules, change far more rapidly, and planners, eager to find new ways to be useful to their clients, need to adapt.