Throughout 2021, there has been much speculation surrounding an increase in income tax rates, a sizable reduction in the gift and estate tax exemption, also known as the applicable exemption amount, and the possible loss of a common tax cost basis adjustment, referred to as basis “step-up,” at death. For now, it appears that the proposed Build Back Better Act legislation is dormant; for exactly how long is anyone’s guess.
Currently, the step-up basis adjustment at death remains intact, as does the applicable exemption amount, which increased to $12.06 million per person on January 1, 2022. The relationship between these two tax concepts is found in the Internal Revenue Code (§1014), which provides that assets included in and passing from a decedent’s estate to an heir receive a basis adjustment equal to fair market value at the time of death. In 2022, married persons must have combined estates of $24.12 million, assuming a well-designed estate plan, before federal estate taxes become a concern. Consequently, income tax planning using estate planning techniques has become a principal tax focus for married persons. A quick illustration of this Internal Revenue Code section will demonstrate the operation of the basis adjustment at death provision for married persons.
Suppose in January 2000 a married couple bought 1,000 shares of Apple Computer Stock at the split-adjusted price of $1.00 per share for a total cost of $1,000. Each spouse is deemed to have a 50% interest in the holding, regardless of which one furnished consideration towards the purchase. Today, this holding is worth approximately $175,000. We will assume the couple own this holding of Apple as joint tenants with right of survivorship. Under current tax law, at the death of the first spouse to die, and as a resident of any “common law” state, only one-half of the value of the stock ($87,500) would be includible in the first spouse’s estate. Since only one-half of the value is included in the estate, only one-half of the basis would be adjusted at death. Following death of the first spouse, the surviving spouse owns 1,000 shares of Apple stock consisting of two tax lots: one lot represents the surviving spouse’s original 500 shares (one-half) with a $1 per share cost basis from January 2000, and a second 500 share lot possessing a $175 per share cost basis from the deceased spouse’s estate in January 2022. On a blended, combined basis, the surviving spouse owns 1,000 shares of Apple at a unit cost basis of $88 per share in the entire 1,000 share position with a fair market value of $175,000. Any sale of the entire position shortly following the first spouse’s death results in a long-term, taxable, capital gain of $88,000.
However, let’s assume the couple reside in a Community Property state, and the Apple stock position was considered to be “community property.” Under this scenario, one-half of the value of the stock would be includible in the estate of the first spouse to die for estate tax purposes, but the full value of the position receives a basis adjustment to fair market value as community property. Thus, on a combined basis, the surviving spouse would own 1,000 shares of Apple at a unit cost basis of $175 per share in the entire 1,000 share position. A sale shortly following the first spouse’s death would result in no capital gains tax payable.
Clearly, married residents in community property jurisdictions have a distinct advantage when it comes to basis adjustments of assets at death of the first spouse. Presently, there are nine (9) Community Property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas & Wisconsin. Over the past several years, the legislatures of some common law states have adopted new legislation permitting the creation of “Community Property Trusts” by its state residents. These states, and their dates of enactment, include Alaska (1998), South Dakota (1998), Tennessee (2010), Kentucky (2020), and now, as of July 1, 2021, Florida. This means that even though the states of Alaska, South Dakota, Tennessee, Kentucky and Florida are traditionally common law jurisdictions, residents may “opt-in” to treat the ownership of some or all their property as Community Property by establishing a Community Property Trust (CPT) and transferring this property to a CPT. It’s worth emphasizing that for residents of these “hybrid” property ownership states, use of a Community Property Trust is not an “all or nothing” situation for married couples. Residents of these states may opt-in to Community Property status and determine which assets they own to be treated as community property.
The benefit of creating and funding a Community Property Trust in a common law jurisdiction offering the opt-in CPT legislation is the opportunity to obtain a dual, full-basis, adjustment in the cost basis of CPT assets in the estate of the first spouse to die. The basic requirements for Community Property Trust creation in a common law state include:
- Spouses only may own Community Property,
- At least one individual resident in the state, a bank possessing trust powers, or a trust company authorized to do business in the state, must serve as the “Qualified Trustee” of the CPT,
- The CPT governing trust document must specifically state that the trust is a CPT and that property held by the trust is to be treated as community property,
- Each spouse has the right to determine the disposition of one-half the property held in the community property trust at death,
- Some of these five states permit non-residents to establish a CPT within the state.
There may be additional requirements, implications and formalities that must be observed when creating a CPT; for this reason, any married couple contemplating the creation of a CPT should seek competent legal counsel in the state in which creation of a CPT is desired. Additionally, the extent to which creditors of one spouse may reach CPT assets should be reviewed with counsel, as well as the implications associated with marriage dissolution. Some estate assets such as deferred compensation and qualified retirement benefits are ineligible for a basis adjustment at death, regardless of the form of property ownership. Last, creation of a CPT should not be implemented in a vacuum.
As is the case with any estate plan review, client objectives and preferences should be paramount, with various tax considerations being weighed based on client objectives and preferences. However, the growing adoption of the CPT by non-community property jurisdictions provides additional planning opportunities for those married persons seeking to minimize the impact of income taxes upon heirs.
The above information is provided for educational purposes only and should not be construed as a specific recommendation or legal or tax advice. Please consult competent professional advice.