“So the conversation has changed to focus on income tax planning and the significant income tax savings you can get when you pass away and get a step-up in basis,” says Paul Lee, senior regional wealth advisor with Northern Trust’s New York office.
“Basis” is what a person paid for the asset and a capital gain or loss is the difference between the basis and the amount the person gets when he sells an asset. In other words, if you sell an asset that is worth more than you paid for it, you will have to pay taxes on the gain. But while capital gains taxes can be significant, this tax can be avoided if the person’s heirs inherit the asset. When someone inherits an asset, the cost basis of the asset is “stepped up to value” on the date of death.
For example, say an elderly parent leaves a home to his children, which is valued at $750,000 on the date he passes away. Because the property was purchased 20 years ago for, say, $250,000, the cost basis is only that: $250,000. So the beneficiaries will not be responsible for capital gains tax on $500,000 worth of gains.
“In a simplistic sense, what you should try to do, if at all possible, is die with only highly appreciated assets,” Lee says. “So you can get a free step-up and your beneficiaries can sell without having to pay a lot of capital gains tax.”
The only strategy for changing the basis of assets, maximizing the step-up and deferring and shifting tax items is the use of partnerships, says Lee. General partnerships, limited partnerships and limited liability companies are all considered pass-through entities and taxed as partnerships. “Partnerships are the only vehicle out there that allow you to manipulate basis or disproportionately allocate tax items in one direction or another, and that allows different people to have different economic interest in the underlying assets,” Lee says.
For example, the estate planning world knows what to do with a client who has two assets, where one has zero basis and the other has high basis. You arrange for the client to keep the lower basis investment until she passes away and try to get the high-basis investment out of the estate because it provides no benefit from the step-up. The problem is that this strategy only works with very high and very low-basis assets. What do you do if a client has two assets and both of them are 50% over basis? According to Lee, you can use a partnership to take the basis off of one asset and move it to the other asset, so you end up with one at 100% and one at zero. The only way you can do that is by comingling the assets in a partnership, letting them sit there for seven years or more and then making the right distributions and elections at the right time to shift the basis from one asset to the other.
Estate Planning In Three-Part Harmony
Mark Parthemer, managing director and senior fiduciary counsel at Bessemer Trust in Palm Beach, Fla., adds that financial advisors should look at estate planning as three parts working together, like a three-part harmony.
First, the trust needs to be properly structured; second, there needs to be a thoughtful use of entities complementing the trust structure, such as limited partnerships and limited liability companies; and third, there needs to be proper asset allocation.
“Without eliminating or reducing a client’s overall diversification … you can create different allocations within different trusts and individual accounts,” Parthemer says. “You still have global diversification, but you have more focused, more appropriate allocations in particular pockets.”
Some of the income taxes can be managed through portfolios that have lower turnover or less income, he says. Private placement life insurance and private placement annuities that are deferred annuities can also be used, he says.
“Those strategies can further the goals of the trust and minimize income tax inefficiency,” Parthemer says.
Private placement life insurance, for example, has received a lot more attention since ATRA. That’s because there’s a deferral on income tax and private placement life insurance provides the flexibility to use an investment advisor of choice. A client may also choose to use a lower-turnover portfolio to minimize capital gains. If the average turnover is 40% a year, maybe the advisor can find an allocation that’s more like 20% a year. By reducing selling and buying, you’re not triggering current gain, so you’re avoiding paying more tax early.
Looking into the future, one of the most important things to keep in mind is flexibility, estate planning professionals say. Flexibility in the distribution of a client’s assets can help beneficiaries. While specific distribution schemes that limit a trustee’s or executor’s ability to maneuver assets certainly serve a role, it is important to remember that circumstances change, assets change value and what once was a perfectly reasonable distribution may not make sense given a change in circumstances. This is especially true in a mobile world where the rules and families are constantly changing.
“Governments helping each other enforce each other’s tax laws? That never used to be the case,” Rubenstein says. “When almost anybody who’s a lawyer today went to law school, we were told countries help each other enforce each others criminal laws because you wouldn’t want someone to commit a crime and then escape to your country. But they never helped each other enforce tax laws. That was a domestic issue. Now that’s turned upside down.”