A few weeks ago, the Internal Revenue Service issued Revenue Ruling 2023-2 — an ominous-sounding ruling that likely doesn’t impact you. But the ruling offers up a good opportunity for a conversation on the tension that exists between estate tax planning and income tax planning.

Estate tax is a tax on your right to transfer property at your death. It involves an accounting of everything you have when you die, including what you own in your own name as well as things you control such as life insurance, retirement accounts and many types of trusts. Failure to report everything at fair market value is tax evasion.

The federal estate tax is relatively easy to calculate. The first $12.92 million of assets is exempt; then a flat 40% tax is applied to the excess. The $12.92 million exemption is set to drop to about half that in 2026, probably around $7 million. Then the 40% flat tax will hit what is above that.

The Illinois estate tax is more complicated to calculate. In practical terms, the first $4 million is exempt from tax, and the effective rate on the excess starts at 28.57% and gradually declines to around 13%.

What if you give assets away while living, so you won’t have them when you die? Giving while living can help in some ways but hurts in other ways.

Related:New IRS rule important given rising land prices

How it works

Say your estate is $9 million. You give away $5 million today, and you die in 2026 with $4 million. The $5 million gift had to be reported to the IRS, and it is taken dollar for dollar off your death tax exemption. With the federal exemption back to $7 million, your gift used up $5 million, so your $4 million estate is still $2 million too large, with tax of $800,000 (40% of $2 million). This is exactly the same as if you made no gifts and died with the $9 million.

How about in Illinois? If you died with $9 million, your Illinois tax would be $801,049. Giving away $5 million and dying with $4 million reduces the tax to about $254,000.

So even if giving away assets while living didn’t help the federal tax, it does lower the state tax. What harm is there?

Most of the farmer’s estate assets would be land, equipment and inventory (grain or livestock). If you sell these, you pay tax on the gain. The gain on land is the sale proceeds you receive minus what you have invested. Pretty straightforward. You bought for $2,000 (your basis), you sold for $10,000, you pay tax on the $8,000 you gained.

When you sell equipment, the gain is the sale proceeds minus whatever you had written off for the purchase. Often equipment has been fully depreciated, so all the sale proceeds are treated as taxable income. Because you wrote off the purchase against ordinary income, the gain on the sale is also taxed as ordinary income.

Related:How your parents’ estate plans can sink yours

Grain is similar to equipment. All your inputs were written off against ordinary income, so all the proceeds when you sell the grain are taxed as ordinary income.

When any of these assets are counted as part of your taxable estate on death, their value reported in your estate becomes the new basis for capital gain purposes. You know of it as stepped-up basis.

So here is the tension. If you give land and equipment away while you are living, those assets will not be included in your estate. There is no step-up in basis on a gift during your life. Your basis is carried over to the recipient.

Choose your poison. If your estate is going to exceed the estate tax exemptions, you might want to give the assets while you are alive. But if you do, your heirs lose the step-up with its income tax advantages. If you think your estate will be at or below the estate tax limits, you want everything to be included so the heirs get the step-up. The grain is sold tax-free, and the fully depreciated equipment can be re-depreciated by your successor.

Back to that ominous-sounding ruling. What prompted it? Some attorneys have been selling trusts they claimed did the impossible: removed assets from your estate but still gave a stepped-up basis. To these wild claims, the IRS said no. You can’t have your cake and eat it, too.

Related:Follow-up course on basics of tax basis

Ferguson is an attorney who owns The Estate Planning Center in Salem, Ill. Learn more at thefarmersestateplanningattorneys.com.