Editor’s note: This is part 10 of an ongoing series about using trusts and LLCs in estate planning, asset protection and tax planning. The effectiveness of these powerful tools — especially for asset protection and tax planning — depends very much on how they are configured to work together and whether certain types of control over assets and property are surrendered by the property owner. See below for links to the other articles in the series.
The combined federal and state capital gains tax rates and the lack of a capital gains tax exemption often make the capital gains tax much more costly than the estate taxes for appreciated property. Despite the frequent fact that a trust maker’s beneficiaries might need to pay more in capital gains taxes upon the sale of property than they would need to pay in estate taxes, because the estate tax rate in 2024 is a scary 40%, many estate planners and clients erroneously worry about the estate tax more than capital gains taxes.
However, many people fail to consider that the 40% federal estate tax applies only to amounts over the $13.61 million federal exemption from gift and estate tax in 2024 — and only a small number of states apply a state-level estate tax. Although the capital gains tax maxes out at a 23.8% federal tax (20% max federal rate plus the 3.8% net investment income tax), many states also apply a state-level tax to capital gains, potentially pushing the combined federal and state-level capital gains tax rate closer to 30%. Just as importantly, the capital gains tax has no federal exemption above the original basis in property, so that the capital gains tax generally applies to all appreciation in the property.
Unfortunately for unwary trust makers, by making a completed gift into an irrevocable trust, the trust maker transfers their basis into the trust under Internal Revenue Code Section 1015. Later, under IRC Section 1014, the beneficiaries of the completed gift trust will be disqualified from a post-death step-up in basis upon the death of the trust maker. Although the federal and state tax laws can change, trust makers with highly appreciated property and a net worth of less than about $20 million for singles and about $40 million for married couples should carefully consider their approach to trust planning so that they don’t fearfully focus on avoiding the estate tax and accidentally stumble their beneficiaries into paying more costly capital gains taxes.
In a situation where estate taxes are very likely to be much higher than capital gains taxes, it may be desirable to make a “completed gift” out of the trust maker’s gross estate and allocate it to the estate tax exemption. A trust will be excluded from the trust maker’s gross estate only if the trust maker does not possess or enjoy the trust property (the trust maker cannot be the beneficiary) and if the trust maker does not control the trust property by not serving as trustee, not serving as trust protector or fiduciary, not serving as an adviser, and the trust maker must not retain powers to appoint trustees, fiduciaries or advisers.
By giving up these beneficial rights and powers over an irrevocable trust and the trust property, the trust maker has made a “completed gift.” Consequently, the trust maker must file a Form 709 gift tax return to report the completed gift to the IRS.
Example. A trust maker has property worth $13.61 million. They make a completed gift of the property to an irrevocable trust by retaining no possession or enjoyment or control over the trust and trust property. The trust maker is not the trust beneficiary, the trust maker does not serve as management trustee or distribution trustee, the trust maker is not on any trust investment or distribution committees, and the trust maker cannot appoint a trust protector. Because the trust maker has given up the powers to possess and enjoy the property and cannot control the trust directly or in conjunction with others, the trust maker must file a Form 709 gift tax return with the IRS to report the completed gift. The gift of 13.61 million uses up all of the trust maker’s lifetime exemption from gift and estate tax, so even though the trust maker must file the gift tax return, no gift tax is owed because the trust maker’s exclusion “exempted” the gift from gift tax. Because the trust maker has given up all control and powers, the trust property will be excluded from the trust maker’s gross estate. It is important to note that the trust property excluded from the trust maker’s estate will also not be eligible for a step-up in basis to reduce capital gains taxes for the beneficiaries when they later sell the trust property.
To minimize transfer taxes (gift and estate taxes), a trust maker must make a completed gift to the trust for federal gift and estate tax purposes by giving up “possession and enjoyment,” as well as control (including control in conjunction with another person) over the trust assets. If a trust maker chooses to completely revoke their rights to the trust property through a “completed gift” to a trust, future appreciation on the completed gift asset will be “frozen out” of the trust maker’s gross estate. The determination of whether a person has retained possession, enjoyment and control (and the issue of whether the assets will be included in the estate and subject to estate tax) is somewhat similar to the asset protection discussion over whether the trust will be protected, though asset protection is primarily based on state laws, and estate tax planning is based primarily on federal tax laws.
The decision of whether to complete the gift by giving up control largely must be made with consideration as to whether the estate is currently subject to transfer taxes, whether the trust property has built-in gains for capital gains tax purposes, and if the trust maker believes the trust assets will increase in value or later become subject to transfer taxes or capital gains taxes. By completing a gift into a trust, a trust maker will either use a portion of their annual exclusion from gift tax (the 2024 annual exclusion is $18,000), or a person may use their lifetime exemption from gift and estate taxes ($13.61 million in 2024). Completing a gift to a trust that is more than the annual exclusion from gift tax requires that the contributor of property file a Form 709 gift tax return, and to be certain that the value of the gift is respected by the IRS, they should obtain a qualified appraisal.
No step-up in basis
It cannot be emphasized enough that after completing a gift to an irrevocable trust that is exempt from estate tax, the irrevocable trust will not be eligible for a step-up in basis upon the death of the trust maker. Although the capital gains taxes are taxed at a lower rate compared to estate taxes (capital gains tax at 15% and estate tax at 40%), many trust makers overlook that they have a significant exemption from estate tax, so often the amount of tax owed on capital gains would be more than the tax owed after the estate tax exemption.
Example. A trust maker wants to set up an asset protection trust that is as tax-efficient as possible, accounting for capital gains taxes and estate taxes. The trust maker’s gross estate has a fair market value of $13.61 million, and the assets have a capital gains tax basis of $2 million. To make the determination about how to set up the asset protection trust to be the most tax-efficient, the trust maker would need to determine whether it is less costly to pay estate taxes rather than capital gains taxes as follows:
Estate tax owed = $0. Calculate estate tax assuming the trust maker is residing in a state jurisdiction that does not assess a state-level estate tax, then even though the trust would be included in the gross estate, the estate would owe $0 in estate tax. Estate tax would be calculated at $13.61 million for the fair market value of the assets, offset by the 2024 estate tax exemption of $13.61 million, with the difference of $0 taxed at 40% for a total estate tax of $0. Put differently, the entire (potentially) taxable gross estate was covered by the exemption from estate tax payments.
Capital gains tax owed = $3.3 million. Capital gains taxes are calculated based on the maximum federal capital gains tax rate in 2024 at 20% federal, plus an additional 3.8% net investment income tax. Assuming the trust beneficiary and the trust are residing in a state jurisdiction with a 5% state capital gains tax rate. This puts the total combined federal and state capital gains tax rate at 28.8%. If the trust maker had irrevocably transferred the assets with a fair market value of $13.61 million and basis of $2 million into a trust, then the trust would receive the trust maker’s basis and have built-in capital gains of $11.61 million taxed at 28.8% once the trust property was sold.
Because the trust maker would owe $0 in estate tax but more than $3.3 million in capital gains taxes, it would be a costly mistake for the trust maker to set up a completed gift irrevocable trust in which the trust property was moved out of the trust maker’s gross estate. The trust maker would transfer into the trust their low basis in the appreciated assets and also give up the step-up in basis upon the trust maker’s death for capital gains tax purposes.
Tax laws could change
It is important to again note that a trust where the trust maker retains powers to possess, enjoy or control the trust assets will be included in the trust maker’s gross estate and get a step-up in basis to reduce capital gains taxes. Where the estate taxes will be less than capital gains taxes because of the estate tax exemption, the trust maker will want to retain powers and control over trust assets so that the trust assets are included in the trust maker’s estate and get a step-up in basis to reduce capital gains tax.
Also important is the fact that the calculation of estate and capital gains taxes is dependent on changing federal and state estate tax exemptions, changing capital gains tax rules, as well as changing property values. All of the changes in tax exemption, tax laws and asset values will be amplified if the trust maker lives for a long time, making an initial tax calculation rough and inaccurate — though still a useful starting point in deciding how to deal with the tradeoff between capital gains taxes and estate taxes.
To state the capital gains and estate tax tradeoff a final time: By giving up possession, enjoyment and power, the gift to a trust will be excluded from the gross estate, but the trust property is not eligible for a step-up in basis for capital gains tax savings.
My next article will focus on clearing up the confusion between grantor trust status, basis step-up and estate tax.
Other Articles in This Series
- Part one: To Avoid Probate, Use Trusts for Estate Planning
- Part two: How Quitclaim Deeds Can Cause Estate Planning Catastrophes
- Part three: Revocable Trusts: The Most Common Trusts in Estate Planning
- Part four: With Irrevocable Trusts, It’s All About Who Has Control
- Part five: Ins and Outs of Domestic Asset Protection Trusts (DAPTs)
- Part six: Irrevocable Trusts: Less Control Equals More Asset Protection
- Part seven: Should You or the Trust Pay a Trust’s Income Taxes?
- Part eight: How to Handle Irrevocable Trust Assets Tax-Efficiently
- Part nine: Repeal the Death Tax? These Are the Taxing Trade-Offs
