Given the changes imposed by the American Taxpayer Relief Act of 2012 ("ATRA"), taxpayers should evaluate the higher income tax rate imposed on ordinary income compared to the estate tax imposed on estate assets. ATRA changed income and estate tax rates as well as the estate exemption for federal tax purposes (and potentially for state tax purposes). The 3.8 percent surtax on net investment income adds another component to the higher income tax rate. With a renewed focus on managing income taxes, taxpayers and their advisors must ensure that they have properly determined the tax basis of the taxpayers' assets.
Basis measures the taxpayer's economic investment in an asset and is used to determine the amount of gain or loss recognized, if any, upon a taxable sale or other disposition. Basis also determines the amount of depreciation allowable. While seemingly a simple concept, the determination of an asset's basis is complicated by several factors, such as how the asset was acquired.
The determination of an asset's basis starts with its cost basis which is just that, the cost to purchase the asset. The cost basis may be adjusted by improvements, carrying charges, capitalized expenditures, selling expenses, restructuring and/or reorganization expenses, depreciation, amortization, and/or depletion.
The basis of an interest in a partnership, LLC or S corporation fluctuates up and down depending on the income, losses and/or distributions that pass through from the entity to the owner. Basis in a partnership or LLC interest ("outside basis") is impacted by the entity's liabilities that are allocable to the owner. The owner's allocable share of the partnership's or LLC's "inside basis" (the entity's basis in the underlying assets) also comes into play and can be affected by certain entity-level elections. Finally, the owner's basis in property distributed by the entity is determined differently depending on the type of entity.
When an asset is transferred via a completed gift, the donee's basis in the asset depends on several factors. The basis of gifts of appreciated property is the donor's basis at the time of the gift, plus gift tax paid (if any) on the net appreciation of the asset's value (but not greater than the asset's fair market value) at the time of the gift.
The basis of gifts of depreciated property (when the fair market value [FMV] is less than the adjusted basis), is a little more complicated and is not determined until the asset is sold. If the FMV of the asset on the date of sale is greater than the donor's adjusted basis (which may be adjusted subsequent to the gift), the basis is equal to the transferred basis. If the FMV of the asset on the date of sale is between the donor's adjusted basis and the FMV on the date of gift, there is no gain or loss recognized. If the FMV of the asset on the date of sale is below both the donor's adjusted basis and the FMV on date of gift, the FMV on date of gift is the applicable basis.
Basis in the assets received by a beneficiary in a distribution from an estate or trust is the adjusted basis of the property in the hands of the fiduciary immediately before the distribution, adjusted for gain or loss recognized by the trust or estate, if any.
Basis of property acquired from a decedent is generally the FMV at the date of death or the alternate valuation date (if elected). Basis of assets that are a right to receive income in respect of a decedent (IRD) do not receive a basis step-up and should be equal to the transferred basis (donor's basis). Assets that were transferred into an Intentionally Defective Grantor Trust (IDGT) do not receive a basis step-up upon the decedent's death and retain the transferred basis. Grantor Retained Annuity Trusts (GRATs) and Qualified Personal Residence Trusts (QPRTs) are wholly-owned grantor trusts and also retain the transferred basis.
Assets subject to a general power of appointment (GPA) held by a decedent should be included in the estate for federal estate tax purposes and should have a basis equal to the estate tax value. There is an IRS technical advice memorandum and several private letter rulings in which the IRS has taken the position that the GPA does not assure a basis step-up if the surviving spouse who granted the GPA had the right to revoke the transfers to the trust during the year prior to the first deceased spouse's death.
Cutting-edge estate planners are crafting trusts to take advantage of a basis step-up from both spouse's estates. One technique is known as a JEST – Joint Estate Step-up Trust, a joint revocable trust created by a married couple who reside in a non-community property state. A different technique is known as a Super Charged Credit Shelter Trust, a credit shelter trust that is a grantor trust with respect to the surviving spouse. These techniques and complex, to some extent untested, and require experienced advisors and well drafted documents.
What we have learned from ATRA is that it is a new game, governed by new laws. The old goal of reducing estate tax has taken a back seat to reducing income tax. In order to understand how to reduce income tax, we need to measure the unrealized gain or loss of the assets. To do that, we must have a good understanding of what the basis is in those assets. As you can see from the above, basis is not a simple matter. Contact your local CBIZ MHM tax professional for help in determining the basis of your various assets and how to leverage that information in your tax planning.
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