The Importance of Income Tax Basis “Step-Up” At Death

Overview

2013 marked the beginning of major law changes impacting estate planning.  Those changes were continued and, in some instances, enhanced by the Tax Cuts and Jobs Act (TCJA) enacted in late 2017.  In particular, the “applicable exclusion amount” was enhanced such that (for deaths in 2019) the associated credit offsets the first $11.4 million in taxable estate value (or taxable gifts).  Consequently, the vast majority of estates are not impacted by the federal estate tax.  The “stepped-up” basis rule was also retained.  I.R.C. §1014.  Under that rule, property included in the estate at death gets an income tax basis in the hands of the heirs equal to the property’s fair market value (known as “stepped-up” basis).  Much estate planning now emphasis techniques to cause property inclusion in a decedent’s estate at death to get the basis increase. 

What are the planning steps to achieve a basis increase?  What about community property?  These are the issues addressed in today’s post.

Basis “Step-Up” Considerations – First Things First

As noted above, under present law, the vast majority of estates do not face federal estate tax at death.  Thus, obtaining a basis increase for assets included in the gross estate is typically viewed as more important.  Consequently, an initial estate planning step often involves a comparison of the potential transfer tax costs with the income tax savings that would arise from a “step-up” in basis.  Unfortunately, this is not a precise science because the applicable exclusion adjusts be for inflation or deflation and could change dramatically depending on the whim of politicians. 

It’s also important to note that a basis increase is of no tax help to the owner of the property that dies.  The only way to capture the income tax benefits of the stepped-up basis adjustment is for the recipients of those assets to dispose of them in a taxable transaction. The degree of the benefit is tied to the asset.  Farm and ranch land may never be sold or may only be sold in the very distant future.  A basis adjustment at death is also beneficial if the asset involved is depreciable or subject to depletion.  An additional consideration is whether the asset involved is an interest in a pass-through entity such as a partnership or an S corporation.

Exceptions To “Stepped-Up” Basis

There are exceptions to the general rule of date- of-death basis.  For example, if the estate executor elects alternate valuation under I.R.C. §2032, basis is established as of the alternate valuation date (typically six months after death).  Also, if the estate executor elects special use valuation under I.R.C. §2032A, the lower agricultural use value of the elected property as reported on the federal estate tax return establishes the basis in the hands of the heirs.  For deaths in 2019, the maximum statutory value reduction for elected land is $1,160,000. 

In addition, for land subject to a qualified conservation easement that is excluded from the gross estate under I.R.C. §2031(c), a “carryover” basis applies to the property.  Also not receiving a basis increase at death is property that constitutes income in respect of a decedent (such as unrecognized interest on U.S. savings bonds, accounts receivable for cash basis taxpayers, qualified retirement plan assets, and IRAs, among other things).  There’s also a special basis rule that involves appreciated property that was gifted to the decedent within one year of death, where the decedent transferred the property back to the original donor of such property (or the spouse of the donor).  The donor receiving the property back will take as a basis the basis that the decedent had in the property immediately before the date of death. I.R.C. §1014(e).  The property basis won’t step-up to fair market value at the date of the decedent’s death.

Community Property Considerations 

The advantage of community property.  On the basis step-up issue, estates of persons living in community property states have an advantage over estates of persons domiciled in separate (common law) property states.  Under community property law, all assets acquired during marriage by either spouse, except gifts, inheritances, and assets acquired with separate property, are considered to be owned equally by the spouses in undivided interests.  The title of an asset is not definitive in terms of ownership in community property states like it is in common law states. The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. 

The ownership portion of the couple’s community property that is attributable to the surviving spouse by virtue of I.R.C. §1014(b)(6) gets a new basis when the first spouse dies if at least one-half of the community property is included in the decedent’s estate for federal estate tax purposes.  This became the rule for deaths after 1947.  Restated differently, there is a basis adjustment of both the decedent’s and surviving spouse’s one-half of community property at death if at least one-half of the community property was included in the decedent’s gross estate under the federal estate tax rules – which would normally be the result.  The federal tax law considers the surviving spouse’s share to have come from the decedent.  The result is a 100 percent step-up in the basis of the property.  Conversely, in a common law property state, property that one spouse owns outright at death along with only 50 percent of jointly owned property is included in the estate of the first spouse to die (and receives a basis adjustment) unless the rule of Gallenstein v. Comr., 975 F.2d 286 (6th Cir. 1992) applies to provide a 100 percent basis step-up for property acquired before 1977.   

Community property spousal trusts.  Three common law property states, Alaska, South Dakota and Tennessee, authorize the creation of “community property trusts” for married couples that establish via the trust an elective community property system.  See, Alaska Stat. Ann. §34.77.100; Tenn. Code Ann. Ch. 35-17-101 – 35-17-108; S.D. Cod. Laws. Ch. 55-17-1 – 55-17-14.   In these states, married couples can classify property as community property by transferring the property to a qualifying trust.  

Under the Alaska provision (enacted in 1998), at least one trustee must be an individual who resides in Alaska or a trust company or bank with its principal place of business in Alaska.  The trust is irrevocable unless it provides for amendment or revocation.  Certain disclosures must be made for the trust to be valid, and the trust must contain specific language declaring that the property contained in the trust is to be community property.  Resident married couples can also execute an agreement to create community property for property that is not held in trust.

The Tennessee provision was enacted in 2010 and allows married couples to convert their property to community property by means of a “Community Property Trust.”  Again, the idea of the trust is to achieve a 100 percent basis step-up for all of the trust property at the death of the first spouse.  Comparable to the Alaska provision, at least one trustee must be an individual that resides in Tennessee or a company that is authorized to act as a fiduciary in Tennessee.   

Under the South Dakota law (enacted in 2016), property contained in “South Dakota Spousal Trust” is considered to be community property even if one spouse contributed more than 50 percent of the property to the trust.  At least one trustee must be a South Dakota resident, which could be one of the spouses.  S.D. Cod. Laws §§55-17-1; 55-3-41.  The trust must state that the trust property is intended to be community property and must specify that South Dakota law applies.  S.D. Cod. Laws §55-17-3.  Both spouses must sign the trust.  S.D. Cod. Laws §55-17-1.  Nonresidents can also utilize such a trust if a trustee is a qualified person that resides in South Dakota.  In addition, significant disclosures are required between the spouses and both must consent and execute the trust.  S.D. Cod. Laws §§55-17-11; 55-17-12.  The trust can be either revocable or irrevocable if the trust language allows for amendment or revocation.  S.D. Cod. Laws. §55-17-4. 

Transfer of farmland.  Can farmland that is owned in joint-tenancy, tenancy-by-the-entirety, or co-tenancy in a common law property state be transferred to a Community Property Trust created under the laws of these states and be treated as community property in order to achieve a full stepped-up basis at the death of the first spouse?  Normally the law of “situs” (e.g. the location of where land is located) governs the legal status of the land transferred to a trust that is administered in another state.  Neither the Alaska, South Dakota, nor Tennessee laws clearly address the legal nature of farmland that is transferred to such a trust from a common law property state, and there appears to be no caselaw or IRS rulings that address the question.  Thus, a preferable planning approach might be to transfer the out-of-state farmland to an entity such as a limited liability company or family limited partnership followed by a transfer of the interests in the entity to the trust.  Perhaps doing so would avoid questions concerning the property law and income tax basis issues associated with the out-of-state farmland.

The UDCPRDA.  Presently, sixteen states (Alaska; Arkansas; Colorado; Connecticut; Florida; Hawaii; Kentucky; Michigan; Minnesota; Montana; New York; North Carolina; Oregon; Utah; Virginia and Wyoming) have enacted the Uniform Disposition of Community Property Rights at Death Act (“UDCPRDA”).  The UDCPRDA specifies how property that was acquired while the spouses resided in a community property state passes at death if the spouses then reside in a common law property state.  The UDCPRDA preserves the community property nature of the property, unless the couple has taken some action to sever community property rights.  It does so by specifying that upon the death of the first spouse, one-half of the community property is considered the property of the surviving spouse and the other half is considered to belong to the deceased spouse.  This should achieve a full basis step-up due to the unlimited marital deduction of I.R.C. §2056, however there aren’t any cases or IRS rulings on the impact of the UDCPRDA on basis step-up under I.R.C. §1014(b)(6).

Other Techniques

The disparate treatment of community and common law property under I.R.C. §1014 has incentivized estate planners to come up with techniques designed to achieve a basis “step up” for the surviving spouse’s common law property at the death of the first spouse.

One way to achieve the basis increase is to give each spouse a power of appointment over the other spouse’s property which causes, on the death of the first spouse, the deceased’s spouse’s property to be included in the decedent’s estate by virtue of I.R.C. §2033 (if owned outright) and I.R.C.§2038 if owned in a revocable trust.  The surviving spouse’s property would also be included in the decedent’s estate by virtue of I.R.C. §2041. The power held by the first spouse to die terminates upon the first spouse’s death and would be deemed to have passed at that time to the surviving spouse.

Another technique involves the use of a joint exempt step-up trust (JEST).  In essence, both spouses contribute their property to the JEST that holds the assets as a common fund for the benefit of both spouses. Either spouse may terminate the trust while both are living, with the result that the trustee distributes half of the assets back to each spouse. If there is no termination, the joint trust becomes irrevocable upon the first spouse’s death. Upon the first spouse’s death, all assets are included in that spouse’s estate.  Upon the first spouse’s death, assets equal in value to the first spouse’s unused exclusion will be used to fund a bypass trust for the benefit of the surviving spouse and descendants. These assets will receive a stepped-up basis and will not be included in the surviving spouse’s estate.  Any asset in excess of the funding of the bypass trust will go into an electing qualified terminable interest property (QTIP) trust under I.R.C. §2056(b)(7).  If the first spouse’s share of the trust is less than the available exclusion, then the surviving spouse’s share will be used to fund a bypass credit shelter trust.  These assets will avoid estate taxation at the surviving spouse’s death.

The JEST technique comes with caution.  Because the surviving spouse (the donor) could revoke the joint revocable living trust at any time, the surviving spouse arguably has dominion and control over the trust assets during the year before and up to the time of the decedent spouse’s death.  That could mean that I.R.C. §1014(e) applies to disallow a basis increase in the surviving spouse’s one-half interest in the trust due to retained control over the trust assets within a year of death.  See, Priv. Ltr. Ruls. 9308002 (Nov. 16, 1992) and 200101021 (Oct. 2, 2000). 

Conclusion

For the vast majority of people, avoiding federal estate tax at death is not a concern.  Some states, however, do tax transfers at death and the exemption in those states is often much lower than the federal exemption.  But, achieving an income tax basis at death is of primary importance to many people.  Community property has an advantage on this point, and other planning steps might be available to receive a full basis step-up at death.  In any event, estate and income tax basis planning is a complex process for many people, especially those with farms and ranches and other small businesses that are trying to make a successful transition to the next generation.  Competent legal and tax counsel is a must.