"We heard that we could get rid of our trusts," are familiar words heard in our law offices today. We use certain trusts to minimize federal estate taxes or “death taxes” as they are known. The much publicized American Taxpayer Relief Act of 2012 instituted a federal estate tax exemption of $5 million that was indexed for inflation as well as the concept of “portability.” “Portability” allows a married couple to fully use the federal exemption by permitting the surviving spouse to claim the unused exemption of the first spouse to die. Another key concept, known as the “marital deduction,” also remained intact. The marital deduction is an unlimited deduction for assets passing to a surviving spouse for certain qualifying trusts that are solely for the surviving spouse.
The 2017 Tax Cuts and Jobs Act ("2017 Act") raised the federal estate tax exemption from the $5 million indexed for inflation to $10 million indexed for inflation. For 2019, the federal estate tax exemption with the inflation adjustment is $11.4 million per person. At the end of 2025, absent additional legislation the exemption will return to the $5.0 million level (indexed for inflation).
Under the 2017 Act, however, the first to die of a married couple can leave all of his or her assets to the surviving spouse and incur no tax and use no federal estate tax exemption thanks to the unlimited marital deduction. Thanks to “portability,” the surviving spouse can then file an estate tax return to elect to carry over the deceased spouse’s $11.4 million and add it to his or her own exemption so that the surviving spouse will have $22.8 million in exemption at his or her death.
Many married couples established their estate plans years ago when the federal estate tax exemption was somewhere between $600,000 and $3,500,000 and when there was no such thing as “portability.” The first to die had to use his or her exemption upon death or lose it forever. Those couples have plans that rely on one or two trusts that estate planning lawyers generally refer to as “A/B Trusts.” These trusts use the estate tax exemption of the first to die and achieve federal estate tax savings by providing that when the first of two spouses dies, assets equal to up to the value of the exemption passes into a trust referred to as “Trust B” rather than passing to the surviving spouse. Trust B is also referred to as the “Family Trust” in many estate planning documents.
After the death of the first spouse to die, Trust B is generally held for the benefit of the surviving spouse and, in many instances, the children of the couple. When the surviving spouse dies, Trust B and all appreciation in Trust B is excluded from the taxable estate of the surviving spouse. In essence, Trust B bypasses the estate of the second spouse to die and minimizes estate taxes by keeping assets out of the estate of the second spouse to die.
For many couples, portability of the estate tax exemption makes an A/B Trust unnecessary, assuming such exemption stays at its current high level. This is because the first spouse to die can leave all of his or her assets to the surviving spouse and still avoid the estate tax by having the surviving spouse use the combined exemptions of both spouses (currently $22.8 million in 2019, assuming no lifetime taxable gifts). In some instances, A/B Trusts may even be a disadvantage because they could cause more income taxes down the line. This is because of a concept known as the “step up in tax basis at death.”
Tax basis is the measuring stick by which taxable gain is determined. When an individual dies, assets that the individual owns generally receive a new tax basis equal to date of death value. For example, if a spouse buys 100 shares of Acme for $100 and the shares are worth $1,000 at such spouse’s death, the shares automatically receive a new tax basis of $1,000 rather than the original $100 purchase price. If the surviving spouse holds those shares until death and the shares are worth $2,000 at that time, then there is a second rise in tax basis. The couple’s ultimate heirs receive a tax basis of $2,000. If the heirs sell the shares for $2,000, there is no taxable gain because the tax basis equals the sales price ($2,000 sales price minus $2,000 tax basis equals zero gain). This concept of the rise in basis is known as the “step up.”
By contrast, if the shares had passed to Trust B (the credit shelter trust discussed above) when the first spouse died, the shares would receive a step up in tax basis to $1,000 at the death of the first spouse. However, when the surviving spouse dies, there would be no rise in basis to $2,000 because the surviving spouse would not be treated as owning the shares at death. Rather, Trust B would be the owner of the shares and not the surviving spouse. As discussed above, the whole point of Trust B is that the surviving spouse does not own the assets and those assets bypass the estate of the second spouse to die.
If you and your spouse have one or two A/B trusts and if you are one of many couples whose aggregate taxable estate is less than $22.8 million, you may be wondering what to do. Should you keep your trusts?
The last thing you may want to do is to undo your estate plan and change the ownership and beneficiary designations on your assets. You may have placed your assets in your trusts in order to avoid probate and you may have named your trusts as the beneficiary of life insurance. You also may have a concern that your estate may grow to exceed tax exemption or that future legislation could decrease your exemption so that your A/B Trusts could become necessary to minimize estate tax. Fortunately, there are a number of alternatives. In many instances, you do not need to undo your trusts and it may make sense to keep them with some modifications.
One possible response to current law is to take a flexible approach with respect to whether to place assets in “Trust B” when the first spouse dies. One way to accomplish this flexible approach is to provide that when the first spouse dies, all trust assets pass to a trust (known as “Trust A”) from which the surviving spouse receives all income and may withdraw all assets at any time. The purpose of Trust A is to allow the surviving spouse to accept the assets of the first to die and withdraw all of those assets. The advantage of Trust A is that the Trust A assets will be included in the surviving spouse’s estate when he or she passes away. Assets that are included in the estate of the surviving spouse will receive a brand new income tax basis when the surviving spouse dies.
A flexible trust would also provide that the surviving spouse has the authority to "disclaim" the right to have assets allocated to Trust A. The surviving spouse disclaims by signing a written document known as a “qualified disclaimer” within nine months of the date of death of the first spouse to die. The effect of the surviving spouse disclaiming is that the surviving spouse is deemed to be deceased solely for purposes of Trust A and the assets then pass into Trust B. Once the assets pass to Trust B, such assets can still be used for the benefit of the surviving spouse for health, maintenance, and support.
Assets that pass into Trust B when the first spouse dies use the federal estate tax exemption of such spouse at the first death. Therefore, if the exemption is ever decreased by federal law after the death of the first spouse, such decrease has no effect on the assets in Trust B because the trust has already taken advantage of the exemption when the first spouse died. Additionally, any appreciation in Trust B after the first spouse dies is excluded from the estate tax when the second spouse dies. Because the assets in Trust B are excluded from the surviving spouse’s estate, however, there is no new income tax basis received for those assets when the second spouse passes away.
For couples who have already instituted A/B trusts and have exerted great effort in funding those trusts and coordinating their beneficiary designations, converting their current A/B trusts into more flexible trusts can be a viable alternative. Sometimes, a simple amendment can accomplish the task without drafting an entirely restated trust. The flexible trust allows the couple to wait until the first of them dies before making a decision as to whether assets should pass into Trust B to achieve estate tax savings or to the surviving spouse to achieve income tax savings by receiving a step up in basis at each death. The surviving spouse can consider whether the rise in income tax basis at both deaths is more important than the possible estate tax savings gained by having assets pass into Trust B.In summary, it may be better to keep your trusts and revise them rather than to dismantle them. Like all planning decisions, there are advantages and disadvantages so discussion with a member of our estate planning team is very important. Additionally, there are other alternatives available to make your trusts more flexible to address the current high levels of exemption. While the focus of this article is federal estate tax, there may be very good non-tax reasons to keep your trusts, including keeping assets in the family bloodline, protecting your beneficiaries' inheritances from creditor's claims, and addressing a beneficiary's special needs.
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