3 Tips to Planning at the Intersection of Income and Estate Taxes

The American Taxpayer Relief Act (ATRA) significantly increased the federal estate tax exemption in 2013 to Estate Taxes$5,250,000 (adjusted for inflation). For estate planners that have traditionally overlooked the income tax during planning discussions, it’s time to take another look at that tax and how and where it intersects with estate taxes.

  1. A refresher course on the relationship between the federal estate tax and the federal income tax.
  2. If there is no federal estate tax, giving the asset away during lifetime can result in overall higher taxes paid by the family. Under the ATRA federal income tax rules, capital gains on appreciated assets will be taxed at a 20% rate for taxpayers with taxable income over $450,000 (joint filers), $400,000 (single filers), $425,000 (heads of households) and $225,000 (married taxpayers filing separately). The capital gains tax is 15% for taxpayers that are below those thresholds. Also under ATRA, there is a 3.8% investment tax that may apply, with a significantly lower threshold. The investment tax is based on modified adjusted gross income (adjusted gross income plus any excluded foreign income) and is $250,000 for joint filers, $200,000 for single filers, $200,000 for heads of households and $125,000 for married filing separately.

    When the asset is given during lifetime, the recipient inherits the income tax basis of the donor if that basis is appreciated (IRC Section 1015(a)). The result may be a significantly higher overall tax paid than if the asset transferred at death. In other words, if the gross estate of the donor is less than the federal estate tax exemption, and there is significant built-in gain in the asset, then giving it during lifetime will trigger the gain when that asset is disposed of or sold.

    When evaluating the tax cost to a lifetime gift, look at the state inheritance and estate taxes too. For states with an estate tax, the exemption is lower than the federal estate tax exemption level, so there may be a state estate tax due even if there is no federal estate tax due. Retaining the asset until death may result in no federal estate tax, a state estate tax, and a fresh start income tax basis for income tax purposes. It is important to run the numbers and determine the lowest combination of those three taxes to make an informed planning decision.

    If property given during lifetime is depreciated at the time of the gift, the donee takes as the income tax basis the fair market value of the property at the time of the gift – but only for the purpose of taking losses. (IRC Section 1015(a)). The donee’s basis is increased by the portion of the gift taxes paid on the gift transfer. (IRS Section 1015(d)(6)).

    When the bequest occurs at death time, the income tax basis receives a fresh start and is stepped up to the date of death value, or the alternate valuation date, if that was elected. (IRC Section 1014). This occurs even if no federal estate taxes are due, meaning that any gain accrued prior to the date of death disappears. On the other hand, if the asset was depreciated for loss recognition purposes, the basis steps down at the time of death and loss cannot be recognized.

    If the taxpayer is domiciled in a community property state, then the surviving spouse’s share of community property is treated as acquired from the decedent and receives the stepped up or stepped down basis even if it was not included in the taxpayer’s federal gross estate. (IRC Section 1014(b)(6)).

    There is a glitch if the decedent had acquired the asset within one year of death and if at the taxpayer’s death the asset passes back to the donor or the taxpayer’s spouse. In that case the basis does not step up (Section 1014(c)). From a planning point of view, if the taxpayer’s health is declining, it makes sense, if possible, to make the gift more than one year prior to death and to someone other than the donor or the taxpayer’s spouse.

    Another exception to the stepped-up basis rules pertains to what is known as “income in respect of decedent” under Code Section 691.  Section 1014(c) provides that these items are to be included in full in the decedent’s gross estate and treated as gross income when realized. Essentially, these assets are taxed at twice – once for the estate tax and once for the income tax. There is an estate tax deduction under Section 691(c) for the estate tax attributable to the inclusion of income in respect of decedent on the decedent’s federal estate tax return.

    Examples of assets subject to both taxes include certain salary and fringe benefits accrued at death, fees and commissions performed during lifetime and paid after death, and retirement plan assets and dividends. If the taxpayer’s intention is philanthropic, however, donating these assets to a qualified charity qualifies for both the estate and income tax deductions.

    In light of the significantly increased federal estate tax exemption, take into account these income tax considerations in determining which assets should be transferred during lifetime, at death, to individuals, and to charities.

  3. Carefully Consider the Tax Consequences of Installment Sales
  4. The older generation may decide to sell the family business or commercial real estate to the next generation on an installment basis, which freezes the value of the asset for estate planning purposes. With the significantly increased federal estate tax exemptions, however, this may no longer be important. For federal income tax purposes, installment sales allow the taxation to be proportionately spread out during the years that the principal payments are made. Since this is a lifetime sale, there is no fresh start basis in the underlying asset and the heir who inherits the note continues to pay income taxes on the payments as they are received.

  5. Determine if Charitable Gifts Should be Made Lifetime or Death Time.

For clients who wish to leave a death time bequest to a charity, if the estate is not subject to federal estate tax then there is no deduction.  If the estate taxes are deferred until the death of the surviving spouse, and the charitable bequest occurs through the estate of the first spouse upon their death, in all likelihood there will be no federal estate tax and therefore no estate tax charitable deduction. Alternatively, the client may decide to make the gift during his lifetime and obtain the charitable income tax deduction, or he may ask his spouse to voluntarily make it during her lifetime if she survives him and take the income tax deduction. His estate planning documents could provide that if that is not done then the charitable bequest is to be paid when they both die.

With the significantly increased federal estate tax exemption, it is increasingly important for advisors to understand and focus on the income tax consequences of estate planning.


Patricia Annino
is a sought after speaker and nationally recognized authority on women and estate planning.  She educates and empowers women to value themselves and their contributions in order to ACCOMPLISH GREAT THINGS in the world – and in so doing PROTECT THEMSELVES, those they love, and the organizations they care about.  Annino recently released an updated version of her successful book, Women and Money: A Practical Guide to Estate Planning to include recent changes in the laws that govern how we protect our assets during and beyond our lifetime.  To download Annino’s FREE eBook, Estate Planning 101 visit, http://www.patriciaannino.com.

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