Estate Planning: Changing Client Perspectives on Estate Taxes

Estate taxes can start at 40% and cap out at 55% when they are levied. When the exemption is exceeded, estate taxes become a concern that clients and their families must address when end-of-life draws near. The reality is that only very wealthy clients holding assets with insufficient liquidity need worry. However, because estate taxes are due within nine months of death it presents a concern to clients and their beneficiaries that must be addressed: how can we avoid or reduce the estate tax?
For 2016, there have been some notable changes in the tax code regarding estate tax and end-of-life income taxes. The major difference this year not present in years past is that the federal estate tax exemption, which is currently $5.4 million per person. This means each individual can protect that sum from taxation, with $10.9 million the exemption for married couples. The majority of beneficiaries won’t need to worry about federal estate taxes but they will, however, need to concern themselves with the federal income tax rate that exceeds 40% when it applies. Accounting for deduction phase-outs, as well as add-ons and state income tax, means that some beneficiaries can be looking at a total income tax rate of about 50%.
This means that a shift in approach when helping clients with their estate planning is necessary. For all but very high net worth clients, the focus has moved from estate tax planning to income tax planning along with avoiding capital gains taxes on assets passed down to heirs.
When a client passes, assets receive a step-up in basis to fair market value, allowing heirs to sell the inherited assets without incurring any capital gains tax. This makes previous strategies to reduce estate taxes, such as trusts or gifting assets which do not allow the step-up in basis, pale in comparison.
The Way Gifts are Given Matters
The shift in the tax code for gifting assets began in 2013 and continues today. This allows the average family some wiggle room when handling estate matters and allows the majority of families to keep their wealth in the family. But even if clients want to gift assets to heirs while they’re still alive, it is important to ensure clients gift correctly to avoid or minimize incurred taxes.
If clients want to gift a residence to an heir while they’re alive so they can protect the property from long-term care costs or even probate, it’s crucial that they don’t just deed the property to the heir. This can cause problems for beneficiaries down the road because they didn’t purchase the property for fair market value. This turns the home into a gift, making a gift tax return necessary.
Gifting a house can also mean that when an heir goes to sell the property, they willl owe income tax on the difference between the value when clients initially purchased the home and the price it sold for in the marketplace. Depending on how long the property was in the family, this can be an astronomical amount. It could be that the original owner gifted the property to his or her children then they, in turn, gifted the property to their children, with the result of a final sale being 50+ years of market appreciation.
These income taxes can be avoided, however, if clients place the home in an irrevocable trust. This would allow the property to be passed on so that the beneficiaries wouldn’t owe any income tax, provided the residence sold for what it was worth as of the date of the client’s death.
When estate planning, it is important to keep in mind several key components of taxation. A prudent advisor will pay close attention to how assets are gifted, especially property, and the various ways that income taxes can eat away at the inheritance. It is quite possible to reduce and, even avoid, estate taxes while also minimizing the impact of income taxes for beneficiaries when all variables are considered and dealt with well before the inevitable passing of a beloved family member.