Building an on-off switch into your estate plan

When planning an estate, there can be tension between estate tax planning and income tax planning. Strategies for reducing estate taxes typically focus on removing assets from your estate, while strategies for reducing income taxes typically focus on including assets in your estate. The right strategy for any one person is the one that will produce the greatest tax savings for his or her family. This article details the conflict and explains why an “on-off” switch in an estate plan can be beneficial.

But that can be difficult to predict. Even if income taxes are the bigger concern now, changes in the tax laws or in your financial circumstances down the road can turn your strategies on their heads.

Fortunately, with careful planning, it’s possible to build an “on-off switch” into your estate plan. The idea is to remove assets from your estate today, but design a mechanism for funneling those assets back into your estate if that turns out to be the better strategy.

Why the conflict?
Generally, the best way to minimize estate taxes is to remove assets from your estate as early as possible (through outright gifts or gifts in trust) so that all future appreciation in value escapes estate tax. But these lifetime gifts can increase income taxes for the recipients of appreciated assets. That’s because assets you transfer by gift retain your tax basis, potentially resulting in a significant capital gains tax bill should your beneficiaries sell them.

Assets held for life, on the other hand, receive a stepped-up basis equal to their fair market value on the date of death. This provides a big income tax advantage: Your beneficiaries can turn around and sell the assets with little or no capital gains tax liability.

Until relatively recently, estate planning strategies focused on minimizing estate taxes, with little regard for income taxes. Why? Because historically the highest marginal estate tax rate was significantly higher than the highest marginal income tax rate and the estate tax exemption amount was relatively small. So, in most cases, the potential estate tax savings far outweighed any potential income tax liability.

Today, the stakes have changed. The highest marginal estate and income tax rates are comparable (40% and 39.6%, respectively) and the estate tax exemption has climbed to $5.49 million for 2017. Let’s suppose Jim’s estate consists of $5.49 million in stock with a tax basis of $1.49 million. If he holds onto the stock and leaves it to his daughter at his death, she’ll enjoy a stepped-up basis. Assuming the stock is still worth $5.49 million, and the capital gain is taxed at a 23.8% rate, Jim’s daughter avoids a $952,000 tax bill when she sells the stock. Had Jim given the stock to his daughter instead, and she then sold it and realized a gain of $4 million, she would have owed the $952,000. There would be no estate tax savings because, in this example, there is nothing left in Jim’s estate.

If, on the other hand, the stock appreciates significantly in value, the outcome will be different. Suppose the stock’s value has increased to $12.49 million when Jim dies, and there’s been no change to either the capital gains rate or estate tax exemption amount. Holding the stock will allow Jim’s daughter to avoid $2,618,000 in capital gains taxes upon the sale of the stock ($11 million × 23.8%), but it will trigger $2.8 million in estate taxes ($7 million × 40%).

Flipping the switch
With a carefully designed trust, you can remove assets from your estate while giving the trustee the ability to direct the assets back into your estate should that prove to be the better tax strategy in the future. There are different techniques for accomplishing this, but typically it involves establishing an irrevocable trust over which you retain no control (including the right to replace the trustee) and giving the trustee complete discretion over distributions.

If it becomes desirable to include the trust assets in your estate, the trustee can accomplish this by, for example, naming you as successor trustee or granting you a power of appointment over the trust assets.

A flexible tool
It’s difficult to predict how your financial circumstances will change in the future and whether Congress will change the income or estate tax laws. An irrevocable trust provides your trustee with the flexibility to react to these changes and achieve the best tax result for you and your family.