Wills and Trusts

Wyatt, Tarrant & Combs, LLP

TRANSFER TAX COST VS INCOME TAX SAVINGS FROM “STEP-UP” IN BASIS – Part II

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Transfer Tax Cost: State of Domicile, Spending, Time Horizon

By way of example, consider a couple with a relatively large estate, $20 million.  As mentioned above, any number of variables will affect whether and to what extent this couple will have an estate tax problem.  It would be impossible to explore each of the variables separately and in detail, but let’s explore a few important variables: decedent’s state of domicile, time horizon, and spending.  Assume for purposes of this exercise:

  1. 50% of the assets are appreciating (modeled as global equities), and 50% have limited appreciation potential (modeled as fixed income);
  2. The couple has both of their Applicable Exclusion Amounts fully available; and
  3. There is no significant time difference between the deaths of each of them (thereby simplifying the issue of how by-pass/credit shelter trust planning[1] or electing portability under § 2010(c)(5)(A) of the Code would change the overall tax picture).

The variables are:

  1. Domicile in California or New York
  2. Time horizon (date of death of the surviving spouse) of 10 or 20 years.
  3. Spending $600,000 (3% of the initial value), $800,000 (4%), or $1,000,000 (5%), after-tax, grown with inflation.
  4. The following table shows our forecast of the probabilities of a Federal estate tax liability (a gross estate greater than the joint Applicable Exclusion Amounts), if the couple is domiciled in California:[2]
Probability of a Federal Estate Tax Liability

(Current $20 Mil. California Residents)

Spending Year 10 Year 20
3% ($600k) 94% 72%
4% ($800k) 87% 46%
5% ($1 mil.) 74% 22%

Note how spending and time horizon significantly affect whether there is a high or low probability of a Federal estate tax liability.

The following table shows our forecast of the probabilities of a Federal estate tax liability (a gross estate greater than the joint Applicable Exclusion Amounts), if the couple is domiciled in New York (specifically New York City):

Probability of a Federal Estate Tax Liability

(Current $20 Mil. New York City Residents)

Spending Year 10 Year 20
3% ($600k) 94% 68%
4% ($800k) 86% 41%
5% ($1 mil.) 71% 18%

Note, the probability of a state estate tax liability is 100% because New York provides for a $1 million exemption per person.  Please also note the probabilities are very similar to the California scenario.  The only difference results from slightly different income tax rates.

While the probabilities of a Federal estate tax liability is interesting data to figure out whether there is likely to be an estate tax liability, the more telling information comes from determining the magnitude of the estate tax liability.  In this context, the total estate tax liability should be couched in terms of an “effective” death tax rate.  In California, the marginal estate tax rate is obviously 40%, but it will only be 40% of the excess value above the joint Applicable Exclusion Amounts at date of death.  Since the “step-up” in basis is based upon fair market value of the assets, the “effective” estate tax cost should be couched in terms of the fair market value of the assets (not just a dollar amount).  For example, if the gross estate is $22 million and the joint Applicable Exclusion Amounts are $12 million at date of death, then the estate tax liability is $4 million (40% × $10 million) and the “effective” estate tax rate is 18.2% ($4 million ÷ $22 million).

The average “effective” estate tax rates (when there is an estate tax liability) for the $20 million California couple, based on our forecasts are:

“Effective” Estate Tax Rate

(Current $20 Mil. California Residents)

Spending Year 10 Year 20
3% ($600k) 16% 11%
4% ($800k) 13% 7%
5% ($1 mil.) 8% 3%

The average “effective” estate tax rates (including New York’s estate tax, but with $2 million of joint state estate tax exemption) for the $20 million New York City couple, based on our forecasts are:

“Effective” Estate Tax Rate

(Current $20 Mil. New York City Residents)

Spending Year 10 Year 20
3% ($600k) 24% 17%
4% ($800k) 20% 12%
5% ($1 mil.) 15% 8%

What then might estate planners do with this type of data, in deciding what to day from a planning standpoint today?  Let’s assume we are dealing with a $20 million couple, spending 3%, and with a joint life expectancy of at least 10 years but likely not 20.  Well, based on the foregoing tables, although the probabilities of an estate tax liability are high, the average “effective” death tax cost is 16% (California) and 24% (New York City).  Whether that liability is too high or too low depends, in large part, on the nature of the types of assets that are likely to be in the estate at date of death.

For example, if it’s likely that a large portion of the estate will be comprised of zero basis long-term capital gain assets, then an “effective” estate tax cost of 16% (California) or 24% (New York) might be a fair price to pay because a taxable sale of that asset without a step-up in basis would cause an income tax liability equal to 37.1% (California income tax rate) and 36.5% (New York City income tax rates) of the value of the assets.  This trade-off becomes even more compelling when the asset is a zero-basis asset that would be taxed at ordinary tax rates but would benefit from a “step-up” in basis, like intangible assets or intellectual property (copyrights and trademarks).  These types of considerations are discussed in more detail in the following section.

When the income tax savings from the “step-up” in basis are sufficient to justify paying the transfer tax cost, the need for ensuring liquidity to pay the transfer tax liability becomes crucial.  While the general trend for the future portends increasingly less transfer tax liability, the need for life insurance (and irrevocable life insurance trusts) continues in this new planning landscape.

Turney P. Berry

Louisville, Kentucky

[1] Generally referring to a trust that is created upon the first spouse’s death, which is not subject to Federal estate tax by virtue of the deceased spouse’s Applicable Exclusion Amount and which is generally created for the benefit of the remainder of the surviving spouse’s lifetime, but is not subject to Federal estate tax in the surviving spouse’s estate.

[2] We are relying upon Bernstein Global Wealth Management’s proprietary analytical tool that marries the benefits of stochastic modeling with our structural model of the capital markets. In each scenario Bernstein simulated 10,000 market scenarios or forecasts for the next 20 years, based initially upon the current state of the capital markets. Bernstein’s proprietary capital markets engine and wealth forecasting model uses proprietary research and historical data to create a wide range of possible market returns for many asset classes over the coming decades, following many different paths of return.  The model takes into account the linkages within and among different asset classes in the capital markets and incorporates an appropriate level of unpredictability or randomness for each asset class.

Leave a reply. Please note that although this blog may be helpful in informing clients and others who have an interest in information privacy and security, it is not intended to be legal advice. The information on this blog also should not be relied upon to form an attorney-client relationship.

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