As of 2016, each person has an aggregate $5.45 million exemption from the federal gift and estate taxes. This exemption can be used either during lifetime or at death (or both, if not all of it is used for lifetime gifts). When determining how best to make use of this exemption, make sure you consider – among other things – the federal income tax basis of any property you want to transfer during lifetime.
Specifically, consider the following tax rules: (1) the recipient of a gift takes the donor’s federal income tax basis in the gifted property (a “carry-over basis”), and (2) a surviving spouse receives property of the deceased spouse with a federal income tax basis equal to the fair market value the property at the time of the first spouse’s death (a “stepped-up basis” if the property has appreciated in value).
For example, 100 shares of stock with basis of $500,000 and fair market value of $5,000,000 have $4,500,000 of “built-in gain” that would be taxable when the shares are sold. If those shares are gifted to a child during the shareholder’s lifetime, the child retains the $500,000 basis (preserving the built-in gain of $4,500,000 that will be taxable on a later sale). But, if that same stock is worth $5,000,000 at the time of the shareholder’s death, the shareholder was married, and the shares were community property or the shareholder’s separate property (as opposed to the spouse’s separate property), and the shares pass to the surviving spouse as a result of the shareholder’s death, then the shareholder’s spouse takes those shares with a new federal income tax basis of $5,000,000 (all the built-in gain is eliminated). Further, if that surviving spouse then gifts the shares to that same child following the shareholder’s death, the child takes the shares with the $5,000,000 income tax basis – eliminating income taxation with regard to the $4,500,000 in former built-in gain on any subsequent sale.
And, if you are concerned that this second option requires the surviving spouse to gift the stock at a much higher value and therefore use up more of his or her federal gift tax exemption, specific provisions may be drafted into in your estate planning documents to allow for the deceased spouse’s unused federal estate tax exemption at the time of death to be “ported” (transferred) to the surviving spouse. So, if neither of the spouses had used any of their exemptions during lifetime and the deceased spouse died in 2016, the surviving spouse would have $10,900,000 in available federal gift and estate tax exemption (rather than “only” $5,450,000). In the above example, if the deceased spouse had not used any exemption during lifetime, such unused exemption is ported, and the surviving spouse gifts the stock to the child when it was worth $5,000,000, the surviving spouse will still have $5,900,000 ($450,000 remaining of the ported exemption and $5.45million of his or her exemption, the latter of which is indexed for inflation) remaining in federal gift and estate tax exemption. Even though the stock value may be higher at the time of the gift, waiting until after the death of the first spouse means built-in gain while both spouses are living may be eliminated, and any future appreciation following the first spouse’s death will be removed from the surviving spouse’s estate.
There are many ways to effectively utilize the federal gift and estate tax exemption. The above example illustrates only one option, and illustrates only one asset of likely many assets owned. It is important to take all moving parts of an estate into consideration when doing this type of planning. Our trust and estates attorneys are available to answer questions, and review existing plans to make sure they still make sense given your circumstances and relatively recent changes in federal tax laws.
* Please note that this article only addresses federal income and estate tax matters specific to the example provided, and does not address any other tax considerations.
Dana Reid is a trusts and estates attorney with 15 years’ experience advising clients on all aspects of estate planning, including business succession and intergenerational planning, and gift, estate, and generation-skipping transfer tax matters. Her work also includes charitable planning, with a focus on creating and supporting private foundations, non-profit public charitable organizations, and charitable remainder and lead trusts. Dana can be reached at firstname.lastname@example.org or directly at 206.757.8116.