Tax and Estate Tax Planning with Transfers to Soon-to-Pass Relatives

Tax and Estate Tax Planning

For introductory purposes for non-tax professionals, when an individual passes, the IRS treats any property they own as though it is sold with a basis (original purchase price plus certain adjustments) of zero; thus, the entire fair market value of the property is subject to taxation. However, the unified credit exempts $5.34m from taxation, so there is no taxation on the first $5.34m of assets. Nevertheless, the first $5.34m of property exempt from taxation is still treated as though it were sold, so the heirs/beneficiaries inherit the property with a tax basis equal to fair market value. This is what we call a “step-up” in basis; it effectively eliminates built-in gain subject to tax. The recipient could sell it the next day and not have any taxable gain.

This led many to consider the idea of gifting assets to a soon-to-pass relative in order to get this step-up in basis and avoid tax on the built-in gains. However, the IRS also realized that taxpayers would think of this.

Under section 1014(e), if the recipient of gifted appreciated property dies within one year of receiving the property and the original person that gifted the property reacquires the property, then the step-up in basis is denied. The spouse of the original person that gifted the property is also covered. This led many practitioners to assume the IRS had prevented the strategy of gifting your 1,000-acre ranch to a soon-to-pass relative. Wrong.

The legislative history of section 1014(e) reveals congressional intent to cover both direct and indirect transfer and acquisitions, including transfers or acquisitions through a trust arrangement. Another defensive measure by Congress. However, in the context of a trust, there are split interests that must be independently valued in accordance with actuarial principles.

Actuarial principles are mathematical calculations used to value certain interests that are difficult to value. For example, if Jane gifts a ranch property to her aunt the week before she passes, and the aunt’s will gives the property back to Jane, then section 1014(e) prevents a step-up in basis.

However, if the will transfers the property to a purely discretionary trust for the benefit of Jane and her children, then the value of Jane’s interest is elusive. In the context of a discretionary trust, the trustee has total and complete discretion to disburse funds. In other words, the trustee could give Jane nothing… or everything.

Also, if the property went back to a split interest trust where Jane merely has a life estate, only a small fraction of the trust would be denied the step-up in basis.

This is yet another opportunity that our clients have fully utilized to avoid the U.S. estate tax.

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