A Gift from the IRS

It’s rare we receive a present from strangers, but the IRS of all sources routinely provides one to surviving spouses.  The assets surviving spouses inherit from their deceased spouse can be stepped up to fair market value, with no federal estate tax impact!

Why don’t spouses take advantage of this?  If the Estate is not federally taxable, as often occurs when the surviving spouse is the sole heir, there is no need for federal estate tax requirements to calculate the fair market value of these closely held business interests. But this is a potentially huge future tax-saving opportunity.

With no support for a step up, the tax basis to the surviving spouse is the decedent spouse’s tax basis at their date of death.  In many instances, this is well below fair market value.

(If the surviving spouse subsequently gifts any ownership interests, the recipient’s basis is the pro rata share of surviving spouse’s basis.  The fair market value determined at the date of the transfer is applied only against the surviving spouse’s federal estate and gift exemption.  It is not a step up to the recipient.  Not fair, but that’s the rule!)

Here’s a simple example.

Mary owns a privately held business.  Her sole heir and surviving spouse John and their children continued to operate the business after Mary’s death.  Because there is no federal tax impact, no step up valuation occurred.  The basis for federal income tax/capital gains purposes for John is the tax basis of the decedent spouse, in this case, Mary.

Mary’s tax basis at her passing was $250,000.  But the business was worth $1 million and no step-up valuation to back this was performed.

Down the road, an offer to buy the business for $1.5 million is accepted.  Assuming no major changes to the tax basis, without the formal step-up, the potential tax on the sale is calculated on $1.25 million.  Had the step-up been established, the potential tax is calculated on $500,000.

Of course, a retroactive valuation is possible.   But such a retroactive valuation is subject to the passing of time and related information and management knowledge “black holes”.  A valuation nearer the date of death would avoid these information gaps.

Which tax scenario would you prefer? Even if the only tax is the lowest capital gains rate of 15%, the savings are huge! All that is required is a filing for portability with the IRS

At the Date of Death Ultimate Company Sale Ultimate Company Sale
No Step Up Step Up
Fair Market Value $1,000,000 $1,500,000 $1,500,000
Basis $250,000 $2,500,000 $1,000,000
Gain Subject to Tax $1,250,000 $500,000
Capital Gains at 15% $187,500 $75,000