As the federal estate tax exemption has ballooned from $1.5 million ten years ago to $5.45 million today, the need for estate tax planning has decreased for many people.  Instead, higher income tax rates that were ushered in under the American Taxpayer Relief Act of 2012 (ATRA) have shifted the focus of estate planning to a new frontier:  income tax BASIS planning.

In this issue, you will learn what income tax basis is, how older estate plans have been designed under old tax laws to include an income tax time bomb, and the options clients have to now update their plans so that their heirs will receive the maximum income tax basis.

The Basics of Income Tax Basis.  In its simplest form, income tax basis is the cost to buy an asset, which includes the purchase  price plus costs and transfer fees.  Basis must be tracked because when an asset

is sold, income tax liability in the form of capital gains is calculated by subtracting the basis from the sales price.  In other words, if the sales price is more than the basis, then the taxpayer must report a capital gain, but if the sales price is less than the basis, then the taxpayer will report a capital loss.

Basis plays an important role in estate planning in two ways.  Basis and lifetime transfers: When property is gifted during life, the recipient of the gift receives the donor's basis in the property.  This is referred to as "carry-over basis." For example, if a client purchases 100 shares of Facebook stock for $60 per share for a total of $6,000 but then gifts the stock to her son when the price is $100 per share, the son's basis in the stock is $6,000 (even though the fair market value is $10,000).  Thus, if the son later sells the stock for $105 per share (or $10,500), he will owe capital gains tax on $4,500 ($10,500 sales price - $6,000 carry-over basis = $4,500 gain).

Basis and transfers after death: When property is transferred after death, in general the inheritor's basis in the property is the fair market value on the date of death.  This is referred to as "stepped-up basis." For example, if a client purchases 100 shares of Facebook stock for $60 per share for a total of $6,000 but then dies and leaves the stock to her son and the price is $100 per share on the date of death, then the son's basis in the stock is stepped-up to $10,000.  Thus, if the son later sells the stock for $105 per share (or $10,500), he will only owe capital gains tax on $500 ($10,500 sales price - $10,000 stepped-up basis = $500 gain).

Planning Tip:  Clients may unknowingly create an income tax bill for their children by gifting property during their lifetimes instead of allowing the children to inherit the property after death.  A common example is when a parent deeds his or her residence to their child to avoid probate.  If the child did not pay their parent anything for the residence, then the parent has made a gift of the residence to the child.  If the parent's basis in the property is $100,000, then the child's basis is $100,000.  If the parent lives in the property for 15 more years and then dies when the value is $500,000, the child's basis is still $100,000.  If the child decides to sell the property shortly after death, the child will owe capital gains tax on $400,000 ($500,000 sales price - $100,000 carry-over basis = $400,000 gain).  If instead the parent had used a revocable trust or a payable on death deed to avoid probate so that the residence passed to the child after death, then the child would not owe any capital gains tax ($500,000 sales price - $500,000 stepped up basis = $0 gain).

A/B Trust Planning:  An Income Tax Basis Concern for Many People.  Including assets in a deceased person's estate is the key to giving heirs a stepped-up basis.  Yet traditional planning for married couples using an A/B Trust Plan deliberately excludes property from the surviving spouse's estate.  An A/B Trust Plan, also known as a Marital Trust/Family Trust Plan, works as follows:

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