“Income, realized capital gains, and estate assets (at death) are all taxed at a flat 20% rate. For the revocable trust, the cost basis of investments increases to the market value on the date of Becker’s death, and the assets are subject to estate taxes. For the irrevocable trust, the cost basis of investments does not change, and the assets are not subject to estate taxes.”
In order to sell USD 1.0 million of Buildco shares while minimizing total taxes, do we want an irrevocable or revocable trust?
I don’t understand why irrevocable is the right answer. They write, “Becker should sell the shares in the revocable trust. Current taxes on realized capital gains will be thesame for either trust (20% × USD 1.8 million). Assets in the irrevocable trust are not subject to estate tax. Assets in the revocable trust are subject to estate taxes upon Becker’s death, at which time the cost basis will be increased to market value. Thus, total taxes are minimized by selling from the revocable trust.”
Why pay taxes twice (capital gains and estate tax) when you can be taxed only once in the irrevocable trust?
The meaning of “cost basis of investment increases to market value” is that you need to pay estate tax on the appreciation from cost basis. Afterwards, the recipient of this asset can carry this investment at the upward adjusted market value. Thus you are only paying one tax (the C/G tax = estate tax)
The meaning of “cost basis of investment does not change” means that the estate can pass this asset on to its recipient without changing its cost base. The new recipient will pay the taxes on the appreciation from cost basis. Thus at minimum, this provides a tax deferral advantage.
Estate tax is a wealth tax, which will be a greater amount than a realized capital gains tax at the same rate. The value in getting the step up is not close to as much as avoiding the estate tax.
EDIT: I guess the cost basis was zero in this problem, Then the thing is you avoid being taxed twice. If you sell the assets in the revocable trust, you would still pay estate tax on the cash. In the irrecovable trust you don’t. Value of step up does not come close to compensating.