Solving the dilemna of estate planning for both capital gains taxes and estate taxes
Virtually every estate plan created for married couples includes the creation of a Family Trust when the first spouse dies. The Family Trust is designed to protect your family from estate taxes but now it can do more harm than good because of the capital gains tax.
The good intentions of traditional planningVirtually all living trusts for marrieds, the trustee is instructed to create a Family Trust on the death of the first spouse. The Family Trust is funded with the assets from the deceased spouse's trust. The purpose of the Family Trust is to make sure the estate tax exemption of the first spouse to die wasn't wasted. Since the combined estate tax rate, Federal and Illinois, is almost 50%, this was certainly a worthy way to plan. (Alternate names for the Family Trust are: Bypass Trust, Coupon Trust, and Credit Shelter Trust).
However, changes in tax law in recent years have caused the industry to make major changes in how we tax plan estates for married couples. The reason is capital gains taxes. I have to take a long way around the block to explain so please stay with me.
Capital gains and the loss of the "Step-up in basis"The general rule is that there are no capital gains taxes when an inherited asset is sold by the beneficiary. For example, suppose the parents buy an asset that can appreciate in value, like a 2-unit building or a stock portfolio, for $200,000. The asset then appreciates in value to $500,000. If the parents sold it, they would pay capital gains taxes on the $300,000 gain. But if they die and leave it to their two children, and then the children sell the asset in order to divide up the cash between them, they pay no capital gains tax. Why not?
The reason is the "step-up in basis" rule. If the children sell it, the tax law gives them a break--a new basis. The new basis is the date-of-death value of $500,000! So if the children sell the building for $500,000 there is no gain over the new $500,000 basis and therefore no tax. It is a very taxpayer friendly rule.
Now remember I said that step-up is the general rule. There are exceptions and one of them is our old pal the Family Trust. If the children inherit the asset on the second death via the Family Trust, they also inherit their parent's basis of $200,000. When they sell the building they will have to pay about the same capital gains tax that their parents would have paid had the parents sold it during their lifetimes.
More harm than good, or the vanishing estate tax savingsYou might say "OK but look at all that money the Family Trust saved them in estate taxes. An estate tax of nearly 50% is a much bigger bite than whatever the capital gains tax would have been." Not so fast.
The estate tax is owed only if the couple's estate exceeds the exemption--and the exemption has soared in recent years. The Federal exemption has gone from $600,000 to $5 million (adjusted for inflation). So even though the percentage of tax is very high, the vast majority of people pay no estate tax at all simply because their estates do not exceed the amount exempted from tax.
OK, now here's the payoff. The consequence of all this is that your children could end up paying a capital gains tax on their inheritance and not benefit at all from the estate tax protection afforded by the Family Trust. The Family Trust can do more harm than good.
Get rid of the Family Trust to preserve the step-up basis? Bad idea!The question is: What do we do about that?
Well, we could just get rid of the Family Trust in order to preserve the step-up in basis. But there are disadvantages to that too.
The Family Trust has many non-tax advantages. It protects the children's inheritance if the surviving spouse remarries, and provides the surviving spouse with a high degree of protection from creditors, lawsuits, divorce from a new spouse, and even bankruptcy. It is a very good trust for the survivor to have for a lot of reasons.
And before we dismiss estate tax vulnerability, remember the survivor could enjoy good fortune. If we don't do a Family Trust in order to avoid capital gains taxes, and the survivor's estate grows it could become vulnerable to estate taxes. (This raises another issue called "portability" which is beyond the scope of this article.)
So what is the solution?There are many solutions depending on the client's situation. This needs to be discussed with your estate planner, but here is a partial list:
1. Plan for the capital gains tax by not creating a Family Trust and accept the risk of an estate tax and loss of protection from outsider (creditor) attack.
2. Plan for the estate tax with the Family Trust and accept the risk of capital gains taxes when the assets are sold after the second death.
3. Draft the trust so the surviving spouse makes the call after the first death. The trust call allow the survivor to assess the situation after the first death and then decide which is the greater risk--capital gains taxes or estate taxes--and fund the Family Trust accordingly. This offers a little more flexibility.
4. There is an option (which I favor) that for the most part provides the best of both worlds. This solution plans to avoid the capital gains tax, which is the most likely scenario for middle class families. But if the client's estate turns out to be large enough to pay estate taxes, the Family Trust swings into action to minimize or avoid the estate tax. All of the other benefits of the Family Trust discussed are retained.
ConclusionWhether it is estate taxes or capital gains taxes, the benefit of the planning is to your children, or whoever benefits from your estate on the second death. The interplay between the estate tax and the capital gains tax is a complex topic that needs to be discussed with your estate planning lawyer.. Please feel free to call us for a consultation at 847-674-0200.