Tax basis planning worth a look if estate taxes aren’t a threat

For many people today, income tax planning offers far greater tax-saving opportunities than gift and estate tax planning. A record-high gift and estate tax exemption — currently $5.49 million ($10.98 million for married couples) — means that fewer people are subject to those taxes.

If gift and estate taxes aren’t a concern for your family, it can pay to focus your planning efforts on income taxes — in particular, on basis planning.

Benefits of a “stepped-up” basis

Generally, your basis in an asset is its purchase price, reduced by accumulated depreciation deductions and increased to reflect certain investment costs or capital expenditures. Basis is critical because it’s used to calculate the gain or loss when you or a loved one sells an asset.

Under current law, the manner in which you transfer assets to your children or other beneficiaries has a big impact on basis. If you transfer an asset by gift, the recipient takes a “carryover” basis in the asset — that is, he or she inherits your basis. If the asset has appreciated in value, a sale by the recipient could trigger significant capital gains taxes.

On the other hand, if you hold an asset for life and leave it to a beneficiary in your will or revocable trust, the recipient will take a “stepped-up” basis equal to the asset’s date-of-death fair market value. That means the recipient can turn around and sell the asset tax-free.

Undoing previous gifts

What if you transferred assets to an irrevocable trust years or decades ago — when the exemption was low — to shield future appreciation from estate taxes? If estate taxes are no longer a concern, there may be a way to help your beneficiaries avoid a big capital gains tax hit.

Depending on the structure and language of the trust, you may be able to exchange low-basis trust assets for high-basis assets of equal value, or to purchase low-basis assets from the trust using cash or a promissory note. This allows you to bring highly appreciated assets back into your estate, where they’ll enjoy a stepped-up basis when you die. Keep in mind that, for this strategy to work, the trust must be a “grantor trust.” Otherwise, transactions between you and the trust are taxable.

Is your basis covered?

Before making any changes to your estate plan, be aware that, if an estate tax repeal is signed into law, it’s possible the step-up in basis at death could go away, too. We can keep you apprised of the latest developments and help you determine whether your family would benefit from basis planning.

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Estate tax relief for family businesses is available … in the form of a deferral

If a substantial portion of your wealth is tied up in a family or closely held business, you may be concerned that your estate will lack sufficient liquid assets to pay federal estate taxes. If that’s the case, your heirs may be forced to borrow funds or, in a worst-case scenario, sell the business in order to pay the tax.

For many eligible business owners, Internal Revenue Code Section 6166 provides welcome relief. It permits qualifying estates to defer a portion of their estate tax liability for up to 14 years from the date the tax is due (not the date of death). During the first four years of the deferment period, the estate pays interest only, set at only 2%, followed by 10 annual installments of principal and interest.

A deferral isn’t available for the total estate tax liability, unless a qualifying closely held business interest is the only asset in your estate. The benefit is limited to the portion of estate taxes that’s attributable to a closely held business.

Eligibility requirements

Estate tax deferral is available if the value of an “interest in a closely-held business” exceeds 35% of your adjusted gross estate. To determine whether you meet the 35% test, you may only include assets actually used in conducting a trade or business — passive investments don’t count.

Active vs. passive ownership

To qualify for an estate tax deferral, a closely held business must conduct an active trade or business, rather than merely manage investment assets. Unfortunately, it’s not always easy to distinguish between the two, particularly when real estate is involved.

The IRS provided welcome guidance on this subject in a 2006 Revenue Ruling. The ruling confirms that a “passive” owner may qualify for an estate tax deferral, so long as the entity conducts an active trade or business. The ruling also clarifies that using property management companies or other independent contractors to conduct real estate activities doesn’t disqualify a business from “active” status, so long as its activities go beyond merely holding investment assets.

In determining whether a real estate entity is conducting an active trade or business, the IRS considers such factors as the amount of time owners, employees or agents devote to the business, whether the business maintains an office with regular business hours, and the extent to which owners, employees or agents are actively involved in finding tenants and negotiating leases.

Weigh your options

As you plan your estate, consider whether your family will be eligible to defer estate taxes. If you own an interest in a real estate business, you may have an opportunity to qualify it for an estate tax deferral simply by adjusting your level of activity or increasing your ownership in an entity that manages the property. Contact us for additional details.

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A “family bank” professionalizes intrafamily lending

If you’re interested in lending money to your children or other family members, consider establishing a “family bank.” These entities enhance the benefits of intrafamily loans, while minimizing unintended consequences.

Upsides and downsides of intrafamily lending

Lending can be an effective way to provide your family financial assistance without triggering unwanted gift taxes. So long as a loan is structured in a manner similar to an arm’s-length loan between unrelated parties, it won’t be treated as a taxable gift. This means, among other things:

  • Documenting the loan with a promissory note,
  • Charging interest at or above the applicable federal rate,
  • Establishing a fixed repayment schedule, and
  • Ensuring that the borrower has a reasonable prospect of repaying the loan.

Even if taxes aren’t a concern, intrafamily loans offer important benefits. For example, they allow you to help your family financially without depleting your wealth or creating a sense of entitlement. Done right, these loans can promote accountability and help cultivate the younger generation’s entrepreneurial capabilities by providing financing to start a business.

Too often, however, people lend money to family members with little planning and regard for potential unintended consequences. Rash lending decisions can lead to misunderstandings, hurt feelings, conflicts among family members and false expectations. That’s where the family bank comes into play.

Make loans through a family bank

A family bank is a family-owned, family-funded entity — such as a dynasty trust, a family limited partnership or a combination of the two — designed for the sole purpose of making intrafamily loans. Often, family banks are able to make financing available to family members who might have difficulty obtaining a loan from a bank or other traditional funding sources or to lend at more favorable terms.

By “professionalizing” family lending activities, a family bank can preserve the tax-saving power of intrafamily loans while minimizing negative consequences. The key to avoiding family conflicts and resentment is to build a strong family governance structure that promotes communication, group decision making and transparency.

Establishing clear guidelines regarding the types of loans the family bank is authorized to make — and allowing all family members to participate in the decision-making process — ensures that family members are treated fairly and avoids false expectations.

Contact us to learn more about the ins and outs of intrafamily lending.

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Asset valuations and your estate plan go hand in hand

If your estate plan calls for making noncash gifts in trust or outright to beneficiaries, you need to know the values of those gifts and disclose them to the IRS on a gift tax return. For substantial gifts of noncash assets other than marketable securities, it’s a good idea to have a qualified appraiser value the gifts at the time of the transfer.

Adequately disclosing a gift

A three-year statute of limitations applies during which the IRS can challenge the value you report on your gift tax return. The three-year term doesn’t begin until your gift is “adequately disclosed.” This means you need to not just file a gift tax return, but also:

  • Give a detailed description of the nature of the gift,
  • Explain the relationship of the parties to the transaction, and
  • Detail the basis for the valuation.

The IRS also may require certain financial statements or other financial data and records.

Generally, the most effective way to ensure you’ve disclosed gifts adequately and triggered the statute of limitations is to have a qualified, independent appraiser submit a valuation report that includes information about the property, the transaction and the appraisal process.

IRS-imposed penalties

Using a qualified appraiser is important because, if the IRS deems your valuation to be “insufficient,” it can revalue the property and assess additional taxes and interest. If the IRS finds that the property’s value was “substantially” or “grossly” misstated, it will also assess additional penalties.

A “substantial” misstatement occurs if you report a value that’s 65% or less of the actual value — the penalty is 20% of the amount by which your taxes are underpaid. A “gross” misstatement occurs if your reported value is 40% or less of the actual value — the penalty is 40% of the amount by which your taxes are underpaid.

Before taking any action, consult with us regarding the tax and legal consequences of any estate planning strategies. In addition, we can help you work with a qualified appraiser to ensure your gifts are adequately disclosed.

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