As Benjamin Franklin once said, “In this world nothing can be said to be certain, except death and taxes.” I believe Mr. Franklin would find it quite interesting that under current tax law, the single greatest ability to avoid tax occurs upon death.
Commonly referred to as “the step up in basis” rule, section 1014 of the Internal Revenue Code allows taxpayers to legally avoid capital gains tax at death. Here is a very quick and simple example of how the “step up” works.
Assume the taxpayer, at age 30, purchased stock in 1950 for a cost of $5,000. The taxpayer never sells the stock and dies at age 96 when the stock is valued at $5,000,000. In this simple scenario, how much do you think is due in tax to the federal government by either the decedent taxpayer or their beneficiary?
What if I told you there is a possible fact set where neither the decedent or their beneficiary would pay a single dime in federal income tax?
First, the decedent taxpayer never sold the stock while they were alive so the taxpayer is not required to report the gain on their personal income tax return.
Second, assuming the taxpayer had never made any taxable gifts in their lifetime, the decedent would not be subject to any federal estate tax because the stock value of $5,000,000 is beneath the current estate tax exemption amount of $5,450,000. The decedent taxpayer’s estate value is still $5,000,000 but the exemption allows this amount to escape any federal estate tax liability.
Third, the beneficiary inherits the stock at the value included in the decedent’s estate, which is the $5,000,000 value at death. This allows the beneficiary to sell the stock and report a cost basis of $5,000,000. If the beneficiary sells the stock for $5,000,000 then the beneficiary will pay zero capital gains tax.
What if the decedent taxpayer had gifted the stock to a family member while still living? In this scenario, the original cost basis of the taxpayer would pass to the family member. If the family member sold the stock for $5,000,000 then a capital gain of $4,995,000 would be reported and subject to capital gains tax. At 15%, the tax would be $749,250.
While death and taxes are as certain now as they were in 1789, the certainty of taxes upon death is not nearly as certain. Make sure you are utilizing existing tax law to protect your assets to the fullest extent authorized by law.
Nick S. Wold, CPA, MA