Estate Planning Series: The New Essential Planning Focus on Income Tax Issues

Income Tax Planning as a Replacement for Transfer Tax Planning as a Primary Focus 

Income tax issues are overtaking transfer taxes as the primary area of planning concern for persons of moderate wealth in an effort to minimize current income taxes and to maximize the basis step up available on death.  A key issue now becomes preserving a step-up basis at the death of each spouse.  For many, a potentially higher capital gains tax in the future, potentially a 20 percent federal capital gains tax, supplemented by perhaps a 3.8 percent net investment income tax, could result in facing a capital gains rate approaching 25 or 30 percent.  

A simple will or revocable trust leaving all of the assets outright to the surviving spouse will achieve a basis adjustment at at the death of both spouses.  

But, if a trust is desired for blended family protection or for management or asset protection purposes or for protecting the surviving spouse financially but denying the surviving spouse ultimate control over the property, use of a QTIP trust will allow a basis adjustment to take place at the surviving spouse's death.  

This planning is sometimes referred to as the use of "portability QTIP" to take advantage of the marital deduction so that the available exclusion of the decedent is not used, which allow the portability rules to move the decedent's DSUE to the surviving spouse.  (See prior Estate Planning Series on Portability)

What about Lifetime Gifting?

Lifetime gifting of appreciating assets may not be as desirable as a planning technique because it may be more advantageous to retain appreciating assets and leave them to heirs, thereby passing on to heirs the highest tax basis at death.  Code Section 1014.  However, see the discussion on Section 529 planning, below. 

The Code 754 Election--LLCs and Partnerships

Another planning tool to consider in the quest for higher income tax basis adjustments is the Code Section 754 election.  This election is available for partnerships and LLCs taxed as partnerships.  When a partner or LLC member dies, his or her heirs receive the partnership or LLC interest of the decedent with a basis equal to the date of death value of such interest.  That is the outside basis of the partnership interest.  The basis of the partnership or LLC in its own assets, the inside basis, is not affected by the death of the partner or member.  

And the taxes for trusts are at a compressed rate of 37 percent . . . . 

Compare the rate for individual taxpayers--single persons reach the 37 percent rate threshold at $518,400 of taxable income in 2020 and married persons filing jointly reach the 37 percent rate threshold at $622,050 of taxable income in 2020.  Although distributing income is a favored planning alternative, it may not always be an available option:  (1) what does the governing instrument require regarding distributions?  (2)  what does the governing instrument or state law say about the distribution of capital gains to any current income beneficiary?  As a general rule, capital gains are defined as and allocated to trust accounting principal and are not readily distributable to income beneficiaries.

In Wyoming, W.S. 2-3-835 provides that the trustee has discretion to include capital gains in income and can make mandatory or discretionary distributions of income on an annual basis pursuant to 643(a) of the Internal Revenue Code.  

In preparing new trusts, it is suggested that the trustee be at least given discretion to distribute capital gains to the income beneficiaries.  For existing trusts, look to state law. In Wyoming, the legislature has crafted the top tools for flexibility, enforcement and asset protection.   However, planning should not lose sight of why a trust was created in the first place.  Appropriate consideration must be given to any relevant non-tax factors that weigh against making a distribution, prior to distributing trust income solely to save income taxes.    

Take Advantage of the 65-day Rule 

An election is available under Code Section 663(b) to have an amount paid or credited to a beneficiary within the first 65 days of a tax year to be treated as if paid or credited during the estate or trust's prior tax year.  This election gives the trustee the opportunity to use information as to the income status of all beneficiaries for the prior year in planning a distribution to minimize the overall family tax burden. 

This election can be used in a number of helpful planning situations, such as shifting income to a lower bracket taxpayer, shifting income to avoid an underpayment of estimated taxes by the trust, or moving income to a beneficiary to take advantage of a beneficiary's net operating loss or excess capital loss.  

Most if not all of the income of a trust will be net investment income subject to the 3.8 percent tax when the 2020 threshold of $12,950 is passed.  Therefore, the trustee may consider taking advantage of the election to make income distributions in order to reduce the trust's exposure to net investment income tax.  

The 65-day election is made by checking the required box on Page 3, Other Information, Line 6 of form 1041 for the trust or estate. 

Take Advantage of Section 529 College Savings Plan 

The permissible making of five years of annual exclusion gifts to a Section 529 plan in the current calendar year with no detriment for gift tax purposes has long been used as part of a gift strategy to shift assets out of the donor's taxable estate.  If the donor dies within the 5 year period, there is a recapture and inclusion of the donor's estate of all or a portion of the gifts made for transfer tax purposes.  If you will not face federal estate tax, which 99 percent of taxpayers will not, with the gifted assets earning tax excluded income within the Section 529 plan, there are many years of potential income tax savings available.  This makes the Section 529 contribution all the more appealing in the current planning environment.  

The 2017 Tax Cuts and Jobs Act allows funds in a Section 529 plan to be used for K-12 expenses for public and private school students up to $10,000 per student per year. The Act also permits funds in a Section 529 plan to be transferred to an ABLE Act plan if the beneficiary is disabled.  

Estate Series 5 will be "What should be done with life insurance".