Step-Up In Basis

Ambrose Kilbride dies leaving his entire 9,000,000-dollar estate outright to his wife, who is a United States citizen. Which statement about the federal estate tax consequence is correct?

1. A.The unlimited marital deduction removes the entire bequest from his taxable estate, so no federal estate tax is due at his death; the assets are exposed to estate tax at his wife's later death.Correct. The deduction is unlimited for a citizen spouse and defers, rather than eliminates, the estate tax.
2. B.The bequest is sheltered only up to the annual gift tax exclusion amount, with the balance taxable at his death.Wrong. The annual gift tax exclusion governs lifetime gifts and has nothing to do with the marital deduction.
3. C.The marital deduction is available only for assets placed in a qualifying trust, not for outright bequests.Wrong. An outright bequest to a citizen spouse is the simplest way to qualify; trusts are one alternative, not a requirement.
4. D.The marital deduction eliminates federal estate tax at both his death and his wife's death.Wrong. It defers the tax to the second death rather than eliminating it.

Why: The unlimited marital deduction allows property passing outright to a surviving spouse who is a U.S. citizen to be deducted in full from the decedent's gross estate, without regard to size. No federal estate tax is therefore due at the first death. The tax is not forgiven, only deferred: the assets join the surviving spouse's estate and are exposed to estate tax at her later death, subject to whatever exclusion is then available to her.

Hollis Rutherford dies in March owning a diversified securities portfolio worth 6,200,000 dollars on the date of death. By September the portfolio has fallen to 5,400,000 dollars. His executor asks whether the estate may use the ALTERNATE VALUATION DATE. Which statement is correct?

1. A.The executor may choose, asset by asset, whichever of the two dates produces the lower value for that asset.Wrong. The election is all or nothing and applies to the entire estate.
2. B.The executor may elect to value the entire estate six months after death, but only if the election reduces both the gross estate and the estate tax; heirs then take basis equal to the alternate values.Correct. Six months, both-reductions condition, all assets, and a matching basis consequence.
3. C.The alternate valuation date is one year after death and may be elected whenever the executor prefers it.Wrong on both counts. The date is six months after death and the election is conditioned on reducing the estate and the tax.
4. D.Electing the alternate date lowers the estate tax while leaving the beneficiaries' basis at date-of-death values.Wrong. Basis follows the values actually used for estate tax purposes, so it drops along with them.

Why: The alternate valuation date is six months after death. The election is available only if using it decreases both the value of the gross estate and the amount of federal estate tax owed, which prevents executors from using it purely to step up basis. It is an all-or-nothing choice applied to the entire estate rather than asset by asset, and property sold or distributed before the six-month mark is valued as of that disposition. When the election is made, the beneficiaries take basis equal to the alternate values, so a lower estate tax today comes at the cost of a lower basis later.

Ignatius Pellworth dies holding two assets: a taxable brokerage account containing stock he bought for $200,000 now worth $900,000, and a traditional IRA worth $900,000 funded entirely with deductible contributions. Both pass to his adult daughter. How do the two assets compare in her hands for income tax purposes?

1. A.The brokerage account receives a step-up in basis to date-of-death value, while the IRA receives no step-up and every withdrawal is ordinary income to her as income in respect of a decedent.Correct. Unrealized appreciation is stepped up; tax-deferred retirement accounts are not, and they keep their ordinary income character in the beneficiary hands.
2. B.Both assets receive a step-up in basis to $900,000, so she may withdraw from either without income tax.Incorrect. There is no step-up for a traditional IRA. Applying one to a tax-deferred account is the most common error on this point.
3. C.Neither asset receives a step-up, so she takes his $200,000 basis in the stock and the IRA is taxable as withdrawn.Incorrect as to the stock. Appreciated property held in a taxable account at death does receive a basis adjustment to date-of-death value.
4. D.The IRA is received free of income tax because estate tax and income tax cannot both apply to the same asset.Incorrect. Both can apply. The relief is an itemized deduction for the estate tax attributable to the IRD, not an exemption from income tax.

Why: The two assets are treated in opposite ways. The taxable brokerage account receives a step-up in basis to its fair market value at death, so the $700,000 of appreciation that accrued during his lifetime escapes income tax entirely and she could sell immediately with essentially no gain. The traditional IRA receives NO step-up. It is income in respect of a decedent, meaning income the decedent had earned or accrued a right to but had not yet recognised, and it retains its ordinary income character in the beneficiary hands. Every dollar she withdraws from the inherited IRA is taxable to her as ordinary income at her own marginal rate, and the account must be drawn down under the applicable inherited-account distribution rules. Where the estate actually paid federal estate tax, the beneficiary may claim an itemized deduction for the portion of that estate tax attributable to the IRD, which prevents the same value from being fully taxed twice.

Three equal owners of Halverson Millwork, a closely held C corporation, want life insurance to fund a buy-sell agreement so that a deceased owner interest is purchased from the estate. They are comparing a CROSS-PURCHASE structure with an ENTITY (stock redemption) structure. Which statement accurately distinguishes them?

1. A.Under the entity plan the surviving owners receive a basis increase equal to the redemption price, which is its main advantage over cross-purchaseThis is the cross-purchase advantage, stated about the wrong structure. In a redemption the corporation is the buyer, so no owner takes on new personal basis.
2. B.The entity plan requires six policies and the cross-purchase three, because the corporation must insure each owner twiceReversed. The entity needs only one policy per owner. Nothing requires insuring an owner twice.
3. C.Both structures require the same number of policies; they differ only in who pays the premiumsPremium payer does differ, but so does policy count. Cross-purchase needs n x (n - 1) policies because every owner insures every other owner.
4. D.Cross-purchase requires six policies here and gives the surviving owners a basis increase in the shares they buy; the entity plan requires three and gives the survivors no new basisCorrect on both dimensions: 3 x 2 = 6 policies under cross-purchase, versus one per owner under the entity plan, and only the personal purchasers get new basis.

Why: Under a cross-purchase plan each owner personally buys a policy on each of the other owners, so with three owners six policies are required, and the surviving purchasers receive a cost basis in the shares they buy equal to what they pay. Under an entity plan the corporation owns one policy per owner - three policies - and redeems the deceased owner shares itself, so the survivors acquire no new basis even though their percentage ownership rises.