If you had to pay tax, would you rather pay 40%, or 23.8%?
 
It’s not a trick question.
 
And yet, depending on how the question presents itself, some people are lured into choosing a 40% estate tax instead of a 23.8% capital gains tax.
 
In this post, we’re going to explain how some people fall into the trap of choosing 40% instead of 23.8%. We’re also going to suggest some planning strategies that may allow clients to avoid and/or minimize both taxes.
 
Cases
This week, I talked with two advisors who have elderly clients (in their 80s and 90s). In both cases, the clients will, barring disaster, have taxable estates. In each case, over half of the client’s net worth is in low basis, publicly traded stock.
 
So far, so good. The problem is that in each case, the client is pursuing the “strategy” of holding the stock until death. The strategic idea is that the heirs will then inherit stock with a “stepped-up” basis.
 
The problem with that “strategy” is that the entire value of the stock will then also be included in the estate. The highest federal estate tax rate is 40%, and 18 states also have an estate or inheritance tax. These state taxes, which are on top of the federal tax, run as high as 20%. Please request a list of those states, and the rates, by clicking here.
 
Stepped-Up Basis
When a person sells a capital asset, such as a share of stock, the general rule is that the person realizes a taxable capital gain. The amount of the gain is the difference between the net sales price and the person’s tax basis in an asset. In the case of stock, the tax basis is usually the price at which the stock was purchased. In the case of real estate and other depreciable assets, the tax basis is computed with reference to the original purchase price, minus any depreciation, and perhaps other adjustments as required.
 
The Internal Revenue Code explicitly states that for most assets passing from a decedent’s estate to an heir, the heir’s basis in the inherited asset will be the fair market value of the asset at the time of the decedent’s death. In the words of the Internal Revenue Code, §1014(a)
 
Except as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be—
(1)  the fair market value of the property at the date of the decedent’s death,
 
And the code then goes on to list many qualifying details and exceptions. This adjustment of the basis is commonly referred to as a “step-up” in basis, or a “stepped-up” basis.
 
For most common assets, including publicly traded stock, the basis does step-up at death.
 
Though politicians sometimes talk about eliminating the step-up in basis at death, it has been in the tax code since 1921. In 1976, as part of the “Tax Reform Act of 1976”, Congress repealed step-up in basis at death. However, due to a hue and cry, the change never actually took effect, and in 1980, Congress retroactively repealed the repeal, and so we still have the step-up at death.
 
The year 2010 was a complete outlier, as that year alone had its own unique set of rules, including no estate tax for people who died that year. But there was also a very limited step-up in basis. A Texas oilman named Dan Duncan died in 2010 with an estate Forbes estimated at $9 billion. Because there was no estate tax that year, his estate paid no estate tax. However, his heirs did not receive a stepped-up basis either. 
 
Value of the Step-Up in Basis
The value to any particular heir of a stepped-up basis depends on several factors, including the amount inherited, the individual’s tax bracket, and the state in which the individual resides.
 
For example, a Floridian in the highest tax bracket will pay tax on long term capital gains at the top federal rate of 23.8% (20% plus the net investment income tax of 3.8%); while the exact same person,  living in California, would pay tax at 37.1% (the 23.8% federal plus California’s top rate of 13.3%).
 
The value of the stepped-up basis is the ability to avoid paying those taxes.
 
Downside: The Asset Must Be in Client’s Estate at Death
Here’s the catch. In order to qualify for a stepped-up basis, the decedent must own the asset in his or her estate at the time of death. That means, among other things, that the client cannot do any estate planning with the asset. Depending on the size of the decedent’s estate, the lack of ability to do any estate planning could cost him a lot.
 
Much good estate planning involves getting assets out of the client’s estate. But as soon as the asset is out of the estate, it no longer qualifies for basis step-up at death.
 
With the federal estate tax alone running to 40%, for clients with taxable estates, it is almost always going to save more taxes, on a dollar-for-dollar basis, to avoid the estate tax than to avoid the capital gains tax.
 
States
Even though 18 states have an estate or inheritance tax, only one state – Connecticut – currently has a gift tax. That means, and we’re oversimplifying here, that clients who live in one of those states may be able to avoid their state’s estate tax  easily by making a gift. Again, holding out for stepped-up basis defeats that strategy.
 
For example, consider a client living in Massachusetts. The Massachusetts estate tax (which was just changed in October), currently exempts the first $2 million from tax upon death. Amounts above $2 million are taxed by Massachusetts at rates up to 16%.
 
Clients with taxable estates, who live in states with state estate taxes (click here to request the list) should be especially mindful about the potential estate-tax cost of holding onto appreciated assets to qualify for the basis step-up at death.
 
The state estate tax can be avoided[1] by gifts (check with local counsel for each state’s particular rules) in all states except Connecticut.
 
Costly Mistake
Clients holding onto assets in their estates in order to qualify for the step-up in basis are probably making a huge mistake. Even in the highest tax states, the combined long term capital gain rate and the state income tax rate are lower than the 40% federal estate tax rate.
 
Clients with taxable estates, who wish to avoid losing more to taxes than is absolutely necessary, should in general prioritize estate planning over holding assets to qualify for stepped up basis.
 
And clients in states with estate or inheritance taxes, even if those clients are not going to be subject to federal estate tax, should consider gifts to reduce or eliminate state level estate/inheritance taxes.
 
How to Avoid Capital Gains Tax Without Waiting for a Basis Step-up
Clients holding assets because they want to wait for a step-up in basis at death should consider the alternative of using a tax-exempt trust, such as a Stock Diversification Trust, a Business Owner Trust, or a Real Estate Shelter Trust to avoid capital gains. Click here to request a guide on these topics. These trusts are also very useful tools in estate tax reduction. Please call or email us to learn more. Call (703) 437-9720 and ask for Katherine or Connor, or email [email protected]. We welcome your comments.

Best,
Roger
 

[1] Check with counsel for rules regarding details and the timing of such gifts.