Is an Income Tax Time Bomb Lurking in Your Estate Plan?
The federal estate tax exemption has grown significantly—from $5 million in 2011 to nearly $14 million in 2025. As a result, far fewer families face federal estate tax issues today. But there’s another kind of tax concern that’s increasingly relevant: income tax basis planning. If your estate plan doesn’t account for this shift, your beneficiaries could face a hefty and avoidable tax bill later.
Let’s explore how basis works, where traditional estate plans may fall short, and how you can update your plan to better protect your loved ones.
Understanding Income Tax Basis
Income tax basis—often just called “basis”—refers to the value used to determine capital gains tax when an asset is sold. While basis usually starts with the original purchase price, it may be adjusted over time based on improvements, depreciation, or the way an asset is transferred.
When you sell an asset, you pay capital gains tax on the difference between the sales price and your basis in that asset. This makes basis a key part of smart estate planning.
Basis comes into play in two primary ways:
1. Carry-Over Basis (Lifetime Gifts)
When you gift an asset during your lifetime, the recipient usually receives your basis in that asset. For example, let’s say you bought 100 shares of stock at $60 per share—a $6,000 total basis. If you gift those shares to your child when the stock is worth $100 per share, your child’s basis remains $6,000. If they sell the stock immediately for $10,000, they’ll owe capital gains tax on the $4,000 gain.
2. Step-Up in Basis (Transfers at Death)
When assets transfer at death, the beneficiary typically receives a step-up in basis to the asset’s fair market value on the date of death. So, if you left those same 100 shares of stock to your child at death—and they’re worth $100 per share—your child’s basis becomes $10,000. If they sell the stock for that same amount, there’s no capital gain and no tax owed.
Because property tends to appreciate over time, this step-up in basis can offer significant income tax savings. That’s why proper planning is essential.
How AB Trusts Can Create Income Tax Basis Problems
Historically, married couples used AB trust planning—sometimes called bypass trusts, marital trusts, or family trusts—to reduce or eliminate federal estate taxes. These trusts were carefully structured to keep some property out of the surviving spouse’s estate. While this strategy was once highly effective for minimizing estate taxes, it can now cause unintended income tax problems.
Here’s how a traditional AB trust plan typically works:
When the first spouse dies, the estate is split between a bypass trust (B trust) and a marital trust (A trust). The bypass trust receives assets equal to the estate tax exemption. The marital trust receives any amount above that.
- Both trusts usually receive a step-up in basis at the first spouse’s death.
- The surviving spouse receives income—and possibly principal—from these trusts, depending on the terms.
When the surviving spouse dies, only the marital trust’s assets are included in their estate. These assets receive a second basis adjustment. The bypass trust assets, however, are excluded from the surviving spouse’s estate and do not receive a second step-up.
This lack of second basis adjustment is where the income tax issue arises. The bypass trust keeps the basis established at the first death, which could lead to large capital gains for your heirs when they sell those assets down the line.
What Does This Look Like in Practice?
Let’s say Joe dies in 2025 with a $15 million estate. His plan uses a bypass trust and a marital trust. Based on the federal exemption of $13.99 million, the bypass trust receives that amount. The remaining $1.01 million goes into the marital trust. Both trusts receive a step-up in basis at Joe’s death.
When Joe’s wife Mary dies in 2030, the marital trust’s assets are included in her estate and receive a second step-up in basis. But the bypass trust’s assets do not. They keep the basis from 2025. If the bypass trust includes highly appreciated assets, the family may face significant capital gains taxes after Mary’s death—taxes that could have been avoided with updated planning.
Smarter Estate Planning with Basis in Mind
The good news? You usually have options. Estate plans that once made sense can often be updated to better reflect today’s tax environment. Here are some common strategies we discuss with clients:
Option 1: Leave Assets Outright to Your Spouse
One option is to forgo the bypass trust entirely and leave all assets directly to your surviving spouse. This way, the assets qualify for the marital deduction, avoiding estate tax at the first death. Then, at your spouse’s death, the assets are included in their estate and receive a second step-up in basis.
This approach can work well—but it’s important to consider potential risks. Assets left outright to your spouse may be vulnerable to creditors, lawsuits, or future remarriage complications. This strategy works best when asset protection is not a primary concern.
Option 2: Keep the Bypass Trust—but Add a General Power of Appointment
If you want to maintain some asset protection, you might choose to keep the bypass trust but give your spouse a general power of appointment over those assets. Doing so will typically cause the bypass trust’s assets to be included in the surviving spouse’s estate—triggering a second step-up in basis at their death.
This strategy allows more control than an outright gift, while still achieving income tax savings.
Option 3: Build Flexibility Into the Plan with a Trust Protector
If you’re not ready to make a final decision now, you can add flexibility to your plan by naming a trust protector or trust advisor. This person—if recognized in your state—can be given the authority to grant a general power of appointment later, based on your family’s needs at the time.
This wait-and-see approach gives your family the ability to pivot in the future without needing to amend the trust itself.
Does Your Estate Plan Contain an Income Tax Time Bomb?
Many clients come to us with older estate plans—especially AB trust plans—that were created during a time when the estate tax exemption was far lower. These plans may no longer align with current law or your financial goals. While the structure may still protect your estate from unnecessary estate taxes, it could be setting your heirs up for unnecessary income taxes.
If you haven’t reviewed your estate plan in the past few years, now is the time. A careful evaluation can help ensure that your plan still works for your current situation—and that it doesn’t include an income-tax surprise waiting down the road.
Schedule Your Basis Planning Review Today
Estate planning is never one-size-fits-all. Your financial goals, family dynamics, and tax exposure all play a role in designing a plan that works for you. At Skvarna Law Firm, we help clients throughout Glendora, Upland, and the surrounding communities navigate complex estate planning questions with confidence.
If you’re unsure whether your plan includes strong basis planning, contact us today. We’re happy to review your current documents, explain your options, and help you create or revise a plan that protects your family, reduces taxes, and provides lasting peace of mind.
About Skvarna Law Firm in Glendora and Upland, California
Skvarna Law Firm provides comprehensive estate planning services to individuals and families across Southern California. With offices in Glendora and Upland, we offer personalized guidance for wills, trusts, probate, and elder law concerns. Whether you’re just getting started or need to revise an existing plan, our team is here to help you make informed, confident decisions about your future. Contact us today to schedule a consultation and take the next step toward peace of mind.
