When families first come to see me, they are almost always worried about federal estate tax.
Very frequently, they have not yet considered federal income tax issues at all.
That focus is understandable. The federal estate tax draws attention because the tax rate is high, and for many years the tax exemption was much lower. For a long time, estate tax planning deserved center stage.
For many families today, however, the conversation has shifted.
Why the Focus Has Changed
With higher federal estate tax exemptions, fewer families actually owe estate tax than they once did. As a result, I sometimes spend as much time focused on federal income tax consequences as I do on minimizing federal estate tax issues.
What I often see in older estate plans is a structure built on an assumed much lower estate tax exemption. Married couples, for example, may have structured transfers at the first death in ways they likely would not choose today if the plan were being drafted under current law.
At the same time, many of the assets in those plans have continued to appreciate. The tax basis of such assets, however, has not. The growing gap creates a significant exposure to federal income tax liability later.
Why Estate Tax Still Gets the Attention
One reason estate tax continues to dominate the conversation is the headline rate. Forty percent is a number that gets people’s attention.
Another reason is familiarity. Estate tax planning has been discussed for decades, while income tax consequences often feel less visible and less immediate.
But visible does not always mean larger.
How Income Tax Shows Up Later — and Bigger
Income tax most often shows up at the death of a loved one.
That is when families sometimes discover that a highly appreciated asset was transferred out of the estate years earlier and is no longer eligible for a step-up in basis. In many cases, the family had assumed that step-up would apply.
A common example involves real property that is integral to a family’s business, such as the land or building from which the business operates. Over time, that property may have appreciated significantly while its tax basis remains relatively low. If the property is held in a way that prevents a step-up in basis at death, the resulting capital gains tax can materially reduce the value ultimately realized by the family when the property is sold or transferred.
That realization often comes as a rude shock.
Gifting Versues Holding Assets
One of the more counterintuitive aspects of the tax law is that gifting assets during life generally does not result in a step-up in federal income tax basis. That benefit typically applies only at death.
As a result, well-intentioned lifetime gifts can sometimes produce worse tax outcomes for heirs than holding the same assets until death, even when federal estate tax exposure is minimal or nonexistent.
Explaining this without jargon is not always easy. I often resort to simple math, written out on paper, because example numbers tend to make the issue clear more quickly than a conceptual explanation.
What Heirs Actually Keep
I frequently review estate plans that were technically successful but still left heirs with avoidable tax costs.
In some cases, families moved appreciated business assets into irrevocable structures to reduce federal estate tax exposure, only to lose the ability to eliminate capital gains tax later. When those assets are eventually sold or transferred, a meaningful portion of their value disappears to federal income tax.
The plan worked, but not in the way the family expected.
How to Think About the Tradeoff
For many families, this ultimately comes down to simple arithmetic.
If one approach reduces federal estate tax but creates a much larger federal income tax liability, and another approach does the opposite, the lower overall tax cost is frequently the better answer. Other considerations matter as well, including asset protection and family dynamics. Even more considerations matter for assets which are part of the family business, such as business succession goals and available business exit strategies. In any event, however, federal income tax can no longer be treated as a secondary concern.
Many plans that were created even fairly recently are now outdated simply because the rules have changed so quickly.
Looking Ahead
Good planning isn’t about predicting every future event. It’s about creating a structure that holds up and remains flexible when something unexpected happens. Families who take the time to coordinate their estate plans and business structures, and maintain them over time, are usually the ones who avoid unnecessary taxes, conflict, and regret later on.
Written by Frank L. Leffingwell
Partner in Charge, Austin