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Step-up in basis and the importance of business valuations for deceased estates and heirs

Posted by Admin Posted on July 28 2016

An information piece for clients and prospective clients by Craig HD Field B.Acc, EA, CPA

The tax issues related to deceased estates tend to be largely ignored in the USA. This is largely due to, in my view, the lack of any real tax liability for most estates. However this should not lead us to ignore one key concept – the step-up in basis.

We need to take a step back to understand how an estate is treated for tax purposes. There are two taxes that come into play with deceased estates; one is income tax, which is based on net income of the estate, and the other is the estate tax, which is based on the assets in the estate. When a person passes away their assets, generally, go into an “estate”. An estate is a separate legal entity with its own income tax number. It has to file an annual income tax return if it has income of more than $600, and an Estate Tax return if it has assets worth more than $5,450,000[i].

Once all the assets of the estate have been collected and all bills paid, the executor of the estate will usually wind up the estate and share all the assets among the beneficiaries or heirs. Often the heirs receive this distribution tax free because usually comprises the after tax assets that the deceased person had owned. The value of the assets inherited by the heir in this process is the fair market value of the assets on the date of death[ii]. This is known as the stepped-up basis.

The stepped-up basis is an important number for anyone who owns an asset that they might one day sell. The tax payable on the sale is based on the difference between the net sale proceeds and the basis. The higher the basis, the lower the tax payable on the sale. The stepped up basis estate does exactly this, raises the basis for a future sale.

For example:

Joe Smith owns ACME Trading Inc., a business that he started in his garage 20 years ago and is now a large and successful business. Joe started the business with a $5,000 loan from his bank which he has long since repaid. Joe thinks the business is worth $1 million now. He isretired and his daughters, Sammy and Abby, are doing a fine job running the show. Joe wants to give the business to them and is considering his options.

 
  • If Joe was to sell the store to them, he would have to pay capital gains tax on the difference between $1 million today and the $5,000 it cost him to start the business 20 years ago, approximately $150,000 in federal tax;
  • If he donated the stock of ACME Trading Inc. to his daughters equally, they would have a basis of $2,500 each in the stock (because in a gift the recipient takes over the asset at the same cost as the donor). This does not save any tax but does defer it until the daughters decide to sell;
  • If Joe was to hold onto the stock in the business and bequeath it to his daughters in his will, he will pay no tax on the transfer to his daughters. Furthermore, the daughters will get the stock at a basis of $1 million, assuming this was the fair market value on the date of death. This effectively saves them approximately $150,000 in federal tax.

The tax savings available using the step-up in basis can be substantial, as can be seen in the above example. Given these savings, it is important that the fair market value basis is well supported and justified. For this reason it is advisable to retain the services of a reputable and professional appraiser, whether it be real estate, equipment or an accredited business valuation.

 For further information on the step-up in basis or to engage Taylor & Morgan for an independent accredited business valuation, please contact us:

 


[i] The basic exclusion amount for 2016.

[ii] Or the alternate valuation date 6 months after the date of death.