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April 12, 2022

Saving the Basis Step-Up When Planning to Reduce Estate Taxes

A very common technique in estate planning to reduce potential estate taxes is to gift assets into an irrevocable trust. The goal is to remove the assets from the grantor’s gross estate. While the grantor typically uses a portion of the unified estate and gift tax credit to make the gift, the estate tax savings comes from the removal of the future appreciation of the trust assets. That is why the best assets to put in the trust are those that are expected to appreciate the most in the near future.

Further estate tax savings can be achieved by structuring the trust so it is considered a “grantor trust,” which means that the grantor will be treated as the owner of the trust assets for income tax purposes. As a result, the grantor is taxed on all income of the trust despite not receiving any of it. By paying the taxes on income generated in the trust, the grantor’s estate is further reduced and the trust assets are preserved and able to grow faster.

The most common way to achieve grantor trust status is for the grantor to reserve the power to reacquire trust assets by substituting other property of an equivalent value. This power is referred to as a “swap power” or “power of substitution.”

The downside of gifting assets into an irrevocable trust, however, is that the income tax basis of the trust assets will be the basis that the grantor had immediately before the assets were transferred into the trust. Since the assets will not be included in the grantor’s estate for estate tax purposes, when the grantor dies they will not receive a step-up in basis to their then fair market value. As a result, when appreciated trust assets are later sold by the trustee or the beneficiaries, the sale will result in capital gains that will be taxed at the federal level up to a maximum 20 percent rate and taxed at the state level as ordinary income.

If the assets are highly appreciated, the gain can be substantial. For example, assume the grantor gifts 50,000 shares of stock to a trust. Each share is worth $100 per share at the time of the gift and the grantor has a basis of $20 per share. The trust terminates several years later when the grantor dies and the stock is worth $250 per share. There was already a $4 million unrealized gain when the gift was made and that gain increased to $11.5 million by the time the grantor died. If we assume a 20 percent federal rate and an 8 percent state rate, the total taxes owed when the stock is sold shortly after the grantor dies would be $3.22 million.

Now, if the grantor’s other assets were substantial enough to use up any remaining estate tax credit, then the removal of the assets from the estate would still be worth it. For example, using the facts in the above example, the grantor used $5 million of his credit to make the gift ($100/share x 50,000 shares) so there is no estate tax savings from that. However, the appreciation that occurred after the gift was made is removed from the estate and would not be subject to estate taxes. If we assume a 40 percent federal rate and a 16 percent state rate, the estate tax savings on the appreciation would be $7.5 million ($150/share x 50,000 shares). Clearly, saving $7.5 million is better than saving $3.22 million. But is there a way to save both? Yes, there is.

If the trust assets are highly appreciated, then the grantor can exercise his swap power to take the assets back and put cash or other low appreciation assets in their place. There will be no change in the grantor’s estate for estate tax purposes since the swapped assets must be equal in value. But now the grantor will own the highly appreciated assets, which will receive the basis step-up when the grantor dies, thereby eliminating all of the gain.

The grantor will need to have extra cash or low appreciation assets in order for this plan to work. In addition, the timing must be right. For example, if the assets are not expected to appreciate much more in the future, then it may be a good time to swap them out. Other factors to consider include the grantor’s age and health because the swap would have to occur before the grantor dies and the ideal time would be right before death to maximize the savings. But be careful, because if you wait too long the grantor may die and the opportunity will be lost.

If you have any questions regarding the content of this blog, please contact Jon McSherry, counsel, at jmcsherry@barclaydamon.com, or another member of the firm’s Trusts & Estates Practice Area.

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