Missing from most law school curricula is perhaps the most important course of all “The Law of Unintended Consequences.”
Consider that in the 90s the tech-bubble along with housing prices grew like topsy. Suddenly many middle-class Americans found themselves to be millionaires, at least on paper. At the same time the Federal Estate tax kicked in with an estate of just $600,000, with a 50% marginal tax rate. So a “millionaire” who passed away might well have an estate tax liability of close to $200,000. Many estates did not have the liquidity to bear that kind of burden without having to sell property, real estate, and equities at fire sale prices.
The solution for many was to put everything into living trusts that upon the death of the first spouse would enable the survivor to split the estate and create a marital deduction trust and a family trust. This plan went under various different names, such as “Marital-Deduction Trust,” Renunciation Trust, or even “A-B” trust, but the essential element was that the survivor could take outright the maximum amount of the exclusion amount ($600,000), and place the rest in a family trust that would pass to the children upon the survivor’s death, thus eliminating any estate tax liability for up to $1.2 million.
That was then. Today, the federal estate tax exclusionary amount for a married couple is a lofty $10.86 million, $5.43 million for an individual. Simply speaking, Federal estate taxation is no longer the driver of estate planning that it once was. Plus, Colorado does not have a functioning inheritance tax either.
Bringing us to the “unintended consequence.” For income tax purposes, assets that are in a living trust maintain their original capital gains basis. So if a couple puts stock purchased at $5.00/share into their living trust, at the death of the surviving spouse that stock will pass to the heirs with that same basis. If it’s worth, say $20/share, then there’s a $15/share capital gains tax that will accompany its sale. Depending upon the income tax bracket of the heir, this will be taxed at the rate of between 15-20%.
On the other hand, assets held in the name of a decedent (and not a trust) that pass by will get a step-up in basis to the value at date of death. Thus, an heir who takes outright gets the value of the asset transferred at the date of death, and subsequent sale will produce no capital gains other than those attributable to the time between death of the testator and the sale of the asset.
So it comes to pass that a perfectly sound technique for avoiding the estate tax in 1995 now has the potential to precipitate a YUGE capital gains liability.
Recently I handled the estate of a centenarian who had begun investing in the 60s and had the vast bulk of her holdings in a living trust. It was worth several million dollars, but had an income tax basis of just several hundred thousand. Boom. Fortunately, there was time before she passed away to transfer the assets into her own name, dissolve the trust, and thus to pass them to her children with no tax consequences–either estate or income. Hundreds of thousands of dollars in taxes were saved.
The point being this. Some of the best laid estate plans can, through the devolution of the law, be affirmatively injurious. If you’re reading this, there’s still time to blow the dust off and do a quick review. You’ll be glad you did.