2016 law journal.

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Good help is hard to find. Luckily, there's plenty here in Business North Carolina's annual Law Journal. Lawyers from four of the top practices in North Carolina offer advice on spotting, preventing and dealing with some of the legal pitfalls common to businesses. Learn how to get your fair shake under eminent domain, make an estate plan that's tax friendly and protect your business in the event an owner goes through a divorce. One article details upcoming additions and changes that will ensure better results are delivered more efficiently at the North Carolina Business Court.

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Virginia S. Carter Zachary F. Lamb

Modern estate planning It's all about the basis

Avoidance of estate taxes is one consideration in estate planning. However, although estate-tax issues currently only affect approximately the wealthiest 1% of the population, everyone should be mindful of income-tax issues, specifically basis, when making estate-planning decisions. Due to recent changes, estate plans and trusts put in place under prior law may no longer efficiently address these income-tax issues.

A decade ago, if a middle-class couple sought legal counsel for estate planning, the first topic of discussion would have been avoiding estate taxes. Estate tax was a priority because a couple with assets over $1.5 million could have found a portion of their estates liable for federal estate tax at a rate between 45 and 47%. With such a hefty tax rate on assets over $1.5 million, it made sense to focus carefully on estate-tax planning.

In 2016, planning to avoid estate taxes is much less important for the vast majority of Americans. With the passage of the American Taxpayer Relief Act in 2012, the federal estate-tax exemption became $5 million per taxpayer, indexed to inflation. This means that this year, each person can transfer $5.45 million before the estate tax kicks in, and a married couple can shelter double that amount.

The favorable change in the estate-tax laws, however, does not mean that tax planning should be ignored in the estate planning process. Instead, the focus has shifted from estate-tax planning to income-tax planning, and specifically to "basis" planning. Ignore basis planning, and your heirs and devisees may be in for an unpleasant surprise when they dispose of an asset.

THE BASICS OF BASIS

"Basis" is an important income-tax concept used to determine the amount of taxable income that results when an asset is disposed of (e.g. sold). The amount of taxable income "realized" is equal to the difference between the value received for the asset minus the seller's basis in the asset.

Generally, the basis in a particular asset will be determined under one of three rules, depending on how the asset is acquired.

  1. Purchased assets: For assets acquired by purchase, the basis in each asset is the purchaser's investment in that asset--typically the amount that the purchaser paid for it when it was purchased. This is the origin of the term "cost basis," which is often used when referring to the basis of a purchased asset.

  2. Gifts: For assets acquired by gift, the recipient's basis in the gifted property generally is equal to the donor's basis in the asset. Conceptually, the donor's basis is viewed as carrying over to the recipient, and this is the origin of the term "carry over basis," which is often used when referring to the basis of an asset received by gift.

  3. Inherited assets: For inherited assets, the basis generally is reset to the fair market value of the property on the date of the deceased owner's death. Any unrealized gains or losses existing as of the date of the owner's death are effectively wiped out. Accordingly, the heir or devisee can sell the property immediately after inheriting it without any income-tax consequences. The adjustment to basis for inherited property is commonly referred to as "stepped up basis," but it is important to recognize that under these rules a "stepped down basis" could result if the asset depreciated in value while the decedent owned it.

    The greater the difference between the amount received when an asset is sold and the seller's basis in it, the more taxable income the seller will realize on the disposition. Thus, effective estate planning should seek to maximize the basis in an asset prior to the date it is sold.

    INDIVIDUAL ASSET ANALYSIS

    Basis planning requires examination of each asset individually. Expected future appreciation of each asset should be considered as well as the anticipated timeline for disposing of it. The tax rates imposed on income realized when an asset is sold can vary based on the type of the asset, as can the rules for determining basis in a particular asset. There is no easy rule of thumb that can be applied uniformly to everyone or every asset when it comes to basis planning. Instead, each person's circumstances must be reviewed asset by asset.

    LIFETIME GIFTS OF DEPRECIATED PROPERTY

    If an asset has depreciated in value since its purchase and it is not anticipated that the asset will be sold during the owner's lifetime, making a gift of the asset while the owner is alive in order to preserve a higher basis should be considered. Gifting the asset during the owner's lifetime will allow the recipient to take the gifting owner's basis in the asset, and if the asset later appreciates, the recipient could sell it and use that basis in computing the taxable income. In contrast, if the owner holds the asset until death, and the recipient receives the asset from the owner's estate, the recipient's basis will be "stepped down" to its fair market value at the time of the owner's death. If the asset subsequently appreciates and is sold, the recipient's taxable income will be greater than if the recipient was given the asset during the owner's lifetime.

    HOLDING APPRECIATED PROPETY UNTIL DEATH

    If an asset has appreciated in value since purchase, the owner should consider holding it until death so that the owner's heirs and devisees will receive a new "stepped up basis" in the asset upon the owner's death. This stepped up basis will allow the heirs or devisees to sell the asset immediately without realizing income and associated tax on the sale. In contrast, sale of the appreciated asset during lifetime or the gifting of it to someone who later sells it will result in realization of taxable income.

    If an owner holds an asset, other than cash or marketable securities, until death, the owner's heirs or devisees should consider obtaining an appraisal of it. The appraisal will document the fair-market value of the asset at the time of the owner's death. If the asset is subsequently sold, the appraisal will substantiate the heirs' or devisees' basis in it.

    RE-EVALUATING ASSETS HELD IN TRUST

    Married couples commonly have estate plans that provide that when the first spouse dies, a trust is established for the surviving spouse. Such trusts, commonly referred to as credit shelter trusts or family trusts, often are structured so that when the surviving spouse subsequently dies, the assets in the trust will not be included in the surviving spouse's taxable estate. Prior to 2012, when the estate-tax exemption amount was relatively modest, these types of trusts often provided great estate-tax savings. However, under current estate-tax law, which impacts less than 1% of Americans, these trusts often have no impact on estate taxes and instead create the negative consequence of increasing the income tax liability of the trusts and their beneficiaries.

    This negative income-tax consequence occurs because the trust's assets are not includible in the surviving spouse's taxable estate. Thus, the basis of the assets is not adjusted (i.e. "stepped up") upon the surviving spouse's death. Essentially, these trusts prevent beneficiaries from having the opportunity to avoid income tax on appreciation that occurs between the first and the surviving spouse's deaths.

    The impact of these trusts on basis and income tax should spur any couple who had estate plans prepared under prior law to re-evaluate those plans to ensure avoidance of any...

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