Income Tax Changing Irrevocable Trust
Written by Craig Wisnom
Posted on Mar 31, 2016
One reason to modify an irrevocable trust is to reduce income tax.
While the income tax and estate tax are very different taxes, there are some areas that relate to each other. Generally, when someone dies owning something, it’s “included” in the person’s estate for estate tax purposes. However, unless all these assets total up to more than $5.45 million, there is no estate tax payable, and no estate tax return is required. That means the “inclusion” is usually just a technical characteristic.
However, under the Internal Revenue Code, there is one income tax result from an asset being “included” in a person’s estate. The cost basis of any asset included in the decedent’s estate is reset to its value as of the date. This is commonly referred to as a “step-up.”
Cost basis is how the IRS determines the capital gains tax when an asset is sold. It’s generally what someone pays for an asset. So, if you buy Microsoft stock for $10,000, your cost basis in that stock is $10,000. If you sell the stock for $100,000, then the capital gain is the difference between the sales price, ($100,000), and the cost basis ($10,000), so in that example the capital gains tax would be based on a total gain of $90,000 ($100,000 – $10,000).
So, when an asset is technically “included” in someone’s estate at death, the asset gets the income tax benefit of the “step-up.” This means the estate or the beneficiaries could sell the asset immediately without triggering any capital gain, no matter what the decedent paid for the asset. So, for most people who don’t have enough assets to trigger an actual estate tax, the estate tax inclusion gives their beneficiaries a nice income tax benefit.
Mr. Smith dies owning $500,000 in Microsoft stock, which he purchased for $100,000. Now, had Mr. Smith sold that stock while he was alive, he would have had income tax on the capital gain he realized at the time of the sale, ($500,000 – $100,000) so taxable capital gains income of $400,000. If, however, he dies, and it goes to his son, son can turn around and sell it for the full $500,000 and not pay any income tax at all! As my tax professor used to tell us, “Wow, another great benefit to dying!”
There is a special nuance for married couples and Arizona’s community property. Namely, when one spouse dies, ALL of the community property, not just the dead spouse’s half, gets this same step-up for cost basis. This is why people moving to Arizona from a non-community property state frequently consider an explicit transmutation of assets to community property.
Now, for “normal” assets, there’s not a lot of ways to change the outcome. You die owning something, it’s included for tax purposes and you get a step up, and if you don’t own, it, you don’t get the step up in cost basis. Under the Federal estate tax rules, a trust you funded and retain significant legal control over, such as your common revocable trust, is treated as part of your taxable estate, and it’s included in your estate like any other asset.
However, if a trust is created by someone else and is irrevocable, the rules are different. This could include a Credit Shelter Trust (aka Family Trust/Bypass Trust/Trust B/Decedent’s Trust) created by a spouse at the death of the first spouse, and it would also include any sort of continuing trust for someone else that lasts throughout their lifetime, such as a Generation Skipping Trust, Dynasty Trust, or Lifetime Protection Trust.
A trust created by someone else for a beneficiary is usually not included in the beneficiary’s estate at death. This was usually intentional, and may have been the main reason behind the continuing trust! That also means there is no step up in basis. While that used to be a very good thing, the changing estate tax landscape means most people will saved more tax if an asset IS included in the estate.
As noted in our other article this month, there are many ways to change an existing trust, and one reason is to give the beneficiary just enough technical power to cause that trust to be included for estate tax purposes. For any client who is Trustee or beneficiary of this type of irrevocable trust, it would be advisable to meet with an attorney to consider these tax impacts and whether any change should be made.