Planning for the Smaller Estate: Income vs. Estate Tax– December 01, 2015 by Andy Whitehair


Posted by Andy Whitehair, CPA/PFS, AEP®

For many years, the primary focus when planning for estates has been to minimize estate tax. However, that tide is changing, as the relative importance of the estate tax is decreasing and the importance of income tax planning is increasing. This is occurring for two main reasons:

1. The American Taxpayer Relief Act (ATRA) made permanent the $5 million estate and gift tax exemption and indexed the exemption amount for inflation ($5,430,000 for 2015), meaningover the next decade99.8% of estates will likely no longer be subject to federal estate tax, according to an April 2015 report, “Recent Changes in the Estate and Gift Tax Provisions,” prepared by the Congressional Research Service.

2. Recent federal income tax changes have included the implementation of a 39.6% top marginal income tax rate, a 20% top capital gains tax rate, a 3.8% tax on net investment income and the return of itemized deduction phase outs.

These developments mean it’s time for individuals, especially those with smaller estates, to take another look at their estate plans and begin shifting their focus to minimizing their income tax burden.

Take a Close Look at Old Estate Planning Documents
Estate plans that have not been updated in several years may still be designed according to prior law, when the estate tax exemption was significantly lower and there was a wider disparity between estate and income tax rates. Let’s look at an example:


Consider a typical situation where the spouse dies and leaves his $3 million estate in a credit shelter trust for the benefit of his surviving spouse under a typical A-B trust arrangement. The surviving spouse has her own assets worth $1 million in the year of her spouse’s death. No estate tax is owed at the first spouse’s death because the $5.43 million exemption amount shelters the amount passing to the credit shelter trust.

Let’s also assume that the surviving spouse lives an additional seven years, during which time the trust assets grow to $5 million and her personal assets grow to $1.5 million. At her death, there is also no estate tax since the trust assets are not included in her estate and her $1.5 million in personal assets are sheltered from estate tax by her own $5.43 million exemption (ignoring the likely increase in the exemption amount due to inflation during the intervening seven years).


In the scenario above, neither spouse’s estate will be subject to estate tax. However, the clients’ respective estate plans ignore the potential impact of income taxes. The Internal Revenue Code provides that the tax basis in inherited property should generally be the fair market value of the property at the decedent’s date of death, assuming the assets are included in the decedent’s estate. This is commonly referred to as “stepped up” tax basis (note that this rule can also result in a step down to fair market value if the asset has declined in value). For a small estate, this basis adjustment can be an extremely powerful tax planning tool.

In addition, the surviving spouse’s assets will receive an adjustment for income tax purposes to fair market value of $1.5 million. If her heirs sell that property, they would only recognize taxable gain or loss on the appreciation or depreciation of the assets since the surviving spouse’s date of death. However, the credit shelter trust assets will not receive this basis adjustment since they were not included in the surviving spouse’s estate. The assets in the trust have an income tax basis (ignoring interim sales) of $3 million, which is the fair market value at the time of the first spouse’s death. When the couple’s heirs sell the trust’s assets, they will have a potential taxable gain of $2 million ($5 million current fair market value less $3 million in tax basis), which, assuming a 30% federal and state combined capital gains tax rate, would result in approximately $600,000 in income tax.

Alternatives to Save More
The typical A-B trust arrangement in our example may not be necessary for the client from an estate tax planning perspective and may be counterproductive for income tax planning purposes. If the client instead relied on portability (Read “Estates That Missed Deadline May Still Elect Portability”) and amended their revocable trust agreements to provide for inclusion of the credit shelter trust’s assets in the surviving spouse’s estate, the client could achieve an income tax basis adjustment to fair market value and avoid passing an income tax liability to heirs. The net savings in this example would be $600,000 of income tax.

There are several alternatives available to help smaller estates plan appropriately for income tax purposes, and each have their advantages and disadvantages. While there are numerous non-tax considerations that ultimately will drive the development of the estate plan, careful attention should be paid to the income tax. Clients with estate plans that have not been examined since recent tax law changes may want to consider discussing their current plans with their advisors to determine whether it still accomplishes their dispositive goals and is effective for both estate tax and income tax purposes.

Adapted from article published by author in Probate Law Journal of Ohio, see Sep/Oct 2015 issue.

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This communication is for information only, and any action should only be taken after a detailed review of the specific situation and appropriate consultation.

Notwithstanding that these materials do not constitute legal, accounting or other professional advice, as may be required by United States Treasury Regulations and IRS Circular 230, you should be advised that these materials are not intended or written to be used, and cannot be used by you or any other person, for the purpose of avoiding penalties that may be imposed under federal tax laws. No written statement contained in these materials may be used by any person to support the promotion or marketing of or to recommend any federal tax transaction(s) or matter(s) addressed in these materials, and any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor with respect to any such federal tax transaction matter.