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Estate Planning – Juggling Income Taxes vs. Estate Taxes

The good news is that you’ve done well financially and established a sizeable net worth. The bad news is that you now have some tough estate planning decisions to make.

High net worth families need to consider whether they should begin gifting assets to their children and grandchildren now, or retain the assets until death and then distribute. With the convergence of income and estate tax rates, parents and their advisors need to analyze numerous and competing variables when implementing a wealth transfer plan that meets their financial goals and needs.

A Complicated Choice

Determining whether to gift or keep assets is more complicated than ever before. The crux of the issue is as follows:

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When deciding which path is the best, consider the following factors:

1.  The life expectancy of the parents;

2.  The fair market value, tax basis, built-in gain and potential for future appreciation and / or income generation; and

3.  State tax laws in both the parents and children’s states of residence. State capital gains tax rates can range from no tax in states like Texas, Florida and Nevada, to 13.3% in California.

Sample Fact Pattern

Let’s assume that the parents jointly own stock in a family-owned business (although it could also equally apply to publicly traded stock, land or other appreciated assets). Let’s say the business is worth $20 million and the parents’ cost basis is $2 million. In this case, we have a built-in long-term capital gain of $18 million. If the company was sold by the parents, a capital gains tax at the federal and state level would be imposed. If they held it until death, the capital gains tax would be eliminated since the parents would get a step-up in basis at death. Thus, significant income taxes would be eliminated if held until death. The estate plan would then bequeath the stock to the next generation.

The downside of the above situation is that the parents would die with a $20 million asset. They could each use their exemption from estate tax ($5,450,000 in 2016). Therefore, $10.9 million of the $20 million asset would no longer be subject to federal estate taxes. However, the remaining $9.1 million would be subject to estate taxes at a top rate of 40% at the federal level. Moreover, the appreciation in the value of the business is subject to estate taxes. A better approach might be to gift some or all of the business to the next generation and let the growth in the business grow in the estate of the next generation, paying estate taxes only when that generation ultimately passes away. In the meantime, substantial estate taxes would be deferred for a generation.

Questions to Ponder

In order to make estate planning decisions that align with the parents’ financial objectives, a number of questions need to be answered:

  • What is the parents’ current and projected net worth before and after the proposed gift?
  • Can the parents afford to make the gift without impacting their own lifestyle?
  • How is the health of the parents? Do they need to retain assets in order to have a pool of liquid funds for the payment of unexpected (or expected) healthcare expenses?
  • What is the current basis of the asset to 
be gifted compared to its current and projected value?
  • What will the recipient do with the gift? Will they hold the asset or sell it and reinvest the proceeds? If held, for how long? If sold, what other assets will be acquired?
  • What is the recipient’s income tax bracket (federal and state)? Is it higher or lower than the parents’ tax bracket?
  • Can the parents better achieve their goals through other gift planning techniques such as an annual exclusion gift (i.e., $14,000 per year per parent / child) or paying education expenses on behalf of the children?
  • Do the parents want to see the children enjoy the gift during their lifetimes?

Does Life Insurance Have a Place in the Analysis?

If the parents were to keep the assets in order to avoid income taxes, life insurance might be needed to provide the cash to finance the estate taxes due on the retained asset. If the parents decided to gift the assets, the estate tax exemption would be reduced or eliminated. Thus, if the exemption was used up because of the gift, estate taxes would be due on the other retained assets. Life insurance could deliver cash at exactly the date when the tax would be due.

Client-Focused Planning

When finalizing a wealth transfer plan, general rules of thumb should not be relied upon. Rather, advisors need to “run the numbers” to determine the optimal approach that works best for the client. This level of in-depth modeling is important. SilverStone Group’s Wealth Transfer advisors are here to help analyze the various estate planning strategies in the context of your unique objectives. For more information on this important topic, contact our estate planning experts.

This article originally appeared in the 2016 | ISSUE THREE of the SilverLink magazine under the title “Estate Planning: Juggling Income Taxes vs. Estate Taxes.” To receive a complimentary subscription to the SilverLink magazine, sign up here.

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