The climate for significant tax reform in Washington is uncertain as talks alternate between heating up and cooling down. But it’s clear that the tax agenda is ultimately a high priority for the Trump administration and Republican leaders in Congress. In particular, the federal estate tax remains a prime target of some lawmakers.

One possible scenario is that this tax will be repealed, with modifications to related tax law provisions. However, this could result in income tax complications for individuals who inherit assets, even with relatively modest values. In many cases, the overall tax consequences for families might be negative.

Current laws of the land

Currently, transfers between spouses generally are exempt from federal gift and estate tax thanks to the marital deduction. Transfers to other beneficiaries, such as your children, are subject to estate tax, but are shielded by a unified gift and estate tax exemption of $5.49 million in 2017 (although that amount will be reduced by prior lifetime gifts).  

Furthermore, your heirs can benefit from a “step-up” in basis when they inherit assets. This means, for purposes of calculating gain or loss on the sale of inherited assets, the assets are valued on the date of your death, instead of valued at your initial cost plus adjustments. This provision replaced rules requiring heirs to “carry over” the basis of inherited assets and thus often incur income tax liability on subsequent sales.

Another benefit of current law is that, when a beneficiary inherits and sells assets, any gain on the sale is automatically treated as a long-term capital gain, regardless of how long the deceased or the heir owned the securities. The maximum tax rate on long-term capital gains currently is 15% (20% for those in the top regular income tax bracket). 

Potential problems for inheritances

Of course, it remains to be seen exactly what shape estate tax reform will take, if any is enacted in the near future. But a repeal of the estate tax is likely to be accompanied by elimination of the “step-up in basis” rule and a return to a carryover basis regime, possibly with exemptions for certain assets like farms and closely held business interests, or an overall exemption. (The temporary 2010 estate tax repeal, for example, came with only a limited step-up in basis allowed on certain asset transfers.)  

To see how this could adversely affect heirs, let’s look at an example.

Suppose that Alan leaves securities to Barbara, his daughter and sole beneficiary. Alan acquired the assets for $1 million and they’re worth $4 million on the date of his death. He hadn’t used any of his gift and estate tax exemption during his life. Under current law, the securities would be valued at $4 million for estate tax purposes, but would be completely sheltered by the $5.49 million gift and estate tax exemption. If Barbara were to sell the securities immediately for $4 million, she would owe no capital gains tax because of the step-up in basis.

Now let’s instead assume that the step-up in basis rule is replaced by a carryover basis rule and no exemption applies. There are no estate tax concerns, but Barbara is saddled with a $1 million basis for the securities. If she sells the securities for $4 million, she must report a $3 million gain. Even if the gain still qualifies for favorable tax treatment as a long-term capital gain, Barbara may owe tax at a rate of up to 20%. That could cost her a staggering $600,000. 

It’s possible that tax reform legislation could also lower capital gains rates. But even then, Barbara would likely have a sizable tax bill, whereas she will have none if these tax reforms aren’t enacted. 

Timing is everything

It’s premature to change your will and other estate planning documents to accommodate what might happen to federal estate tax laws, especially if the language is intended to provide maximum tax benefits under current law. Just be prepared to move quickly if and when Congress revamps the rules. We’re here to help when/if that time comes.

Sidebar: Gifts of securities with tax strings attached

A lifetime gift of securities to a child may be sheltered by the annual gift tax exclusion without eroding the $5.49 million gift and estate tax exemption. For 2017, the maximum gift tax exclusion is $14,000 per recipient ($28,000 for gifts split by a married couple).

However, the income tax rules for subsequent sales depend on whether the sale would have produced a loss or a gain had you sold the securities instead of gifting them:

• If the sale would have produced a loss and your child then sells at a gain, your child’s basis is the same as yours. If your child then sells at a loss, the basis is the fair market value on the transfer date.
• If the sale would have produced a gain, your basis is used to calculate any future gain or loss by your child.

Depending on the situation, it may be preferable to sell the stock, claim a tax loss and then gift the proceeds to your child.