Death-Bed Tax Planning: Some Basics

November 05, 2018
BH Trust Company discusses tax planning for the terminally ill or elderly, covering the basic necessities and more advanced techniques around death-bed tax planning.

Death, taxes, and childbirth! There’s never any convenient time for any of them.

Margaret Mitchell, Author of “Gone with the Wind”

Americans are both living longer and dying in higher numbers than ever before. By 2020, more than 56 million individuals in the U.S. will be over the age of 65, compared with about 35 million in 2000. Meanwhile, there will be approximately 2.8 million deaths in 2020, up from just 1.7 million in 1960. By 2050, the projected number of Americans living over age 65 is set to surpass 86 million, with a projected 4.2 million deaths per year.1 Striving for old age is not always a good thing, as many individuals move into a protracted incapacity. As medical and technological advances are made, terminal illnesses can be managed for longer periods of time to defer the inevitable. For example, the number of Americans living with Alzheimer’s and other types of dementia is expected to increase by 300% to 13.8 million by 2050.2

Despite these sobering numbers, most individuals in the U.S. do not have a last will and testament, nor have they planned for their potential incapacity. Unfortunately, too many wait until it is too late – not only unnecessarily forgoing many of the tax and creditor protection benefits of sophisticated planning, but also leaving their families the difficult, time-consuming burden of administering an estate without any direction. Consider, for example, someone who dies without a will and without having discussed a plan for her death with family. After a potentially lengthy probate process (that could have been avoided with advance planning), where a judge no one has met determines who will be appointed as executor of the decedent’s estate, the assets of the decedent must be collected and reported. This is only one of many jobs with which an executor is tasked, yet imagine the difficulty in simply finding all the assets. Did the decedent have a safety deposit box that someone knew about? Did she have any outstanding loans payable by or to her? Did she have an online brokerage account where she had opted out of paper statements? Were her email address and password readily accessible to determine whether she had such online accounts or other financial obligations? The list of potential difficulties that may arise in simply finding the decedent’s assets is dauntingly endless.

Perhaps many who die without a plan pass away unexpectedly or too soon. However, the statistics mentioned earlier make clear that an increasing number of individuals will at least have some warning, whether it be a significant advanced age or a terminal illness diagnosis, creating an opportunity to plan for a more imminent death. Indeed, many calls Brown Brothers Harriman (BBH) receives regarding estate planning begin with some unfortunate and terrible news, followed by a sober “What now?” While this article is directed at those who have received a terminal illness diagnosis or are of an advanced age and who have done little planning and must immediately, its suggestions can apply to anyone, young or old, healthy or ill.

The Basic Necessities

The starting point for creating a plan for the terminally ill or those of an advanced age is to put into place some basic estate planning documents. These include the following:

  • Last Will and Testament: This document disposes of an individual’s assets; names an executor to manage one’s estate, including the filing of a final income tax return and estate tax return; and, importantly for those with young children, names guardians of minor children. To avoid probate, unnecessary cost, administrative burdens and publicity, one should consider using a revocable trust to dispose of assets instead.
  • Power of Attorney: This document names an agent or agents who can act on an individual’s behalf when making certain delineated financial decisions. Some states allow the agent to act at any time, while others allow the agent to act only when the maker becomes incapacitated. Generally, an agent’s powers should be broad and potentially include the power to conduct additional estate planning in the event of the maker’s incapacity.
  • Healthcare Proxy and Living Will: This set of documents outlines an individual’s medical wishes in various states of medical incapacity and names an agent to make healthcare decisions on one’s behalf.
  • Beneficiary Designation Forms: These documents name the beneficiaries for certain non-probate assets, such as insurance proceeds and retirement accounts.

Individuals who have any of these documents already in place should consider reviewing them if diagnosed with a terminal illness or as they reach an advanced age to ensure they still align with their wishes. All too often, many documents were put in place some time ago and no longer make sense; for example, it is common that an ex-spouse or deceased sibling is named in a document or beneficiary designation form. As part of this review, one should also consider creating a list of assets, including financial accounts, where each account is held and a contact person at each institution. At BBH, we often compile this list into one organized book with our clients’ help. Finally, individuals should consider their wishes for funeral arrangements and, if their state allows, execute a Disposition of Remains document that lists their wishes and names an agent to carry them out. Simply getting these basic documents in place will ensure that one is well ahead of the curve.

Tax Planning for the Terminally Ill

A couple Internal Revenue Code (IRC) provisions severely circumscribe one’s ability to make gifts just before death. These so-called death-bed transfer provisions were designed to prevent someone from waiting until the last minute to begin tax planning. One of these rules pulls any gifts made by a donor within three years of death back into his or her estate, effectively eliminating any gift or estate tax advantages of such a gift. In other words, one must survive a gift by three years in order to receive the tax benefits of doing so. However, annual exclusion gifts are a notable exception to this rule. A dying individual may make gifts up to the annual exclusion amount ($15,000 in 2018 and 2019) to as many individuals as he or she wishes. An individual with three children and seven grandchildren, for example, could gift up to $150,000 this year, saving up to $60,000 in federal estate taxes.

A couple Internal Revenue Code (IRC) provisions severely circumscribe one's ability to make gifts just before death. These so-called death-bed transfer provisions were designed to prevent someone from waiting until the last minute to being tax planning.  

In addition, even if the terminally ill donor is not expected to survive three years, it may still make sense to consider making gifts of certain assets, particularly when the donor believes that the assets will rapidly appreciate. The reason for this is that gifts made within three years are includible in the donor’s estate at a value equal to the asset’s value at the time of the gift. Any subsequent appreciation after the gift is made is not captured and returned to the estate for estate tax purposes.

The second death-bed transfer rule affects the so-called step-up in basis at death by disallowing inheritors to receive this benefit if they gifted the asset to the decedent within the last year. To see how this works, consider that generally any asset includible in a decedent’s estate receives an adjustment to its basis to the fair market value at the time of death (or six months after if the alternate valuation date is used). For example, if Jack buys XYZ stock for $10 per share and dies five years later when the stock is valued at $100 per share, the cost basis of $10 per share is “stepped up” to the fair market value at death of $100 per share, effectively wiping out the stock’s built-in capital gain. This is a boon for inheritors, since the asset’s associated income tax bill is eliminated. However, if Jack’s wife, Diane, gifts the XYZ stock to Jack less than one year before he dies, and Diane inherits the asset back under Jack’s will, no step-up in basis is allowed.3

These two rules can create some challenges for those with limited time remaining. However, a number of potential tax strategies are still available. For example, if there are assets with significant built-in losses, it may make sense to sell the asset in order to realize the loss rather than wait until death. While the basis adjustment rules are generally referred to as the stepped-up basis rules (the indomitable hope for a never-ending bull market is to thank for this name), the rules can in fact work to adjust the basis downward for those assets with built-in losses, meaning an inheritor does not get the benefit of claiming the loss on his or her own income tax return. Therefore, it may be best to have the donor realize these losses and use them to offset other gains in his or her portfolio. Alternatively, a gift of the asset could be made to the spouse (as long as the donor spouse does not receive it back within one year), who could then choose to hold or sell the asset and then claim any subsequent gain or loss on his or her own return.

Finally, there could potentially be planning options with retirement accounts for the terminally ill. A regular IRA or similar retirement account that is taxable when distributions are made can often be converted to a Roth account, which is not taxable when distributions are made. The downside is that the conversion from an IRA to a Roth IRA is a taxable event, meaning that the plan owner must pay income taxes on the full value of the plan’s assets. However, the potential upside could outweigh the upfront cost for a couple of reasons. First, assets outside of the IRA can be used to pay for the conversion, which reduces the plan owner’s taxable estate. Second, the conversion allows heirs of the Roth account to continue to receive tax-exempt withdrawals. In short, a one-time estate-reducing tax payment can effectively eliminate the taxability of the entire retirement plan for many years to come, creating a boon to both the plan owner and his or her heirs.

Despite the IRC’s efforts to curtail so-called death-bed planning, many opportunities – only a few of which were mentioned here – still abound. Of course, it is highly recommended to do as much planning in advance as possible, but should you or a loved one require any last-minute planning, please do not hesitate to contact a BBH relationship manager or wealth planner.

1 U.S. Census Department.
2 Alzheimer’s Association.
3 Many (and perhaps most) estate planning lawyers believe that there are easy ways to get around this rule. Unfortunately, the Internal Revenue Service has not issued regulations or guidance regarding this rule, so anyone trying to circumvent it should proceed with some caution. A tried-and-true way, however, is to simply make a gift that will not come back to the donor within a year by, for example, making a gift that will ultimately go to anyone other than the original donor.

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners.© Brown Brothers Harriman & Co. 2020. All rights reserved. PB-03792-2020-07-13

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