Written by attorney Thomas Edward Rossmeissl

Hidden Dangers in Outdated Trusts

The estate tax laws have been in a state of flux over the last several years, making estate planning somewhat challenging for many clients. The recent changes in the estate tax laws that occurred earlier this year are “permanent," however, at least in the sense that they do not have an automatic expiration date. (In other words, they are permanent until changed, but with no visible changes on the horizon.)

How might this affect you? If your trust was prepared more than a few years ago, it was prepared at a time when the estate tax exemption was much lower and estate tax rates were much higher than they are now. In order to ensure that no estate taxes would be owed when the first of you were to die, your trust may require a division of the estate into two to three sub-trusts after the first death: a Survivor’s Trust (containing the survivor’s share), a Bypass Trust to take advantage of the deceased spouse’s estate tax exemption, and a Marital Trust to hold any remaining portion of the deceased spouse’s estate if the estate tax exemption is not large enough to protect all of the deceased spouse’s share. That was a fairly standard estate tax planning technique to ensure that no estate taxes would be owed on the first death no matter how large the estate was at that time, and that at the survivor’s death, only the Survivor’s Trust and the Marital Trust would be potentially subject to estate tax. The Bypass Trust would pass free of transfer tax to the children, with the estate tax having effectively been paid already by using the deceased spouse’s exemption. The Bypass Trust assets would be subject to a potential capital gains tax when they were eventually sold, based on appreciation since the first death, but the capital gains tax was significantly less than the estate taxes saved by using this structure, so this approach made good economic sense for many people.

Now, however, the surviving spouse can protect a $5.25 million estate and a married couple can protect a $10.5 million estate, amounts that will be adjusted for inflation in future years. For most people, there is little need to force a division of the estate into two or three separate trusts after the first death simply in order to minimize estate taxes unless the overall estate is worth more than $10.5 million. Nevertheless, the structure of a trust created years ago does not automatically change with changes in the law, and it probably does not offer the flexibility to simply disregard the creation of multiple trusts at the first death. Unless the trust is changed, those sub-trusts will be created when the first spouse dies. In other words, the trust structure is not keeping pace with the tax laws and may still require a division of the estate into at least two trusts at the first death, even if there is no need to do so for estate tax savings reasons.

This creates a couple of risks:

First, dividing the estate into two trusts after the first death will impose a certain amount of inconvenience on the survivor. While the survivor’s half of the estate will be held in the Survivor’s Trust (a revocable trust to benefit the survivor), the rest of the estate will be held in an irrevocable trust that benefits the survivor, but which will require an annual income tax return to be prepared for it, separate accounts for any liquid assets, etc. Also, the children will be vested remainder beneficiaries of the irrevocable trust at that point and will have some right to know about how those assets are being managed and consumed by the surviving spouse. Some clients are now opting to have the entire estate pass to the Survivor’s Trust so that the survivor has maximum flexibility and minimum inconvenience for the lifetime of the survivor.

Second, there is a risk of a built in capital gains tax for up to half of the estate. Property transferred at death generally receives a full step-up in basis (or step-down in basis) to fair market value as of date of death. This means that generally, capital gains taxes are minimized, especially for any assets sold soon after the death. This will be the case for assets held in the Survivor’s Trust: they will receive a basis adjustment when the survivor dies, minimizing the capital gains taxes to be paid when the assets are later sold. The assets held in the Bypass Trust, however, will not receive an additional step-up in basis on the survivor’s death. Instead, the basis adjustment will only occur at the first death. So, to the extent these assets appreciate in value, the beneficiaries will owe capital gains tax when the assets are eventually sold. This tax tradeoff – lower capital gains on a portion of the estate when sold to avoid higher estate taxes on a larger portion of the estate – was a pretty good deal when the capital gains tax rate was low, the estate tax rate was much higher, and the estate tax exemption amount was more modest than it is today. But now that the estate tax exemptions are so high, the tax planning done more than three or four years ago creates a risk that up to half of the estate will be subject to potentially significant capital gains tax when sold after the survivor’s death, all without the benefit of a corresponding savings on estate taxes.

Is there a solution? Fortunately, there is an easy solution. Instead of requiring multiple sub-trusts to be created at the first death, all of the estate can simply stay in a single trust for the benefit of the surviving spouse. All the assets will be in the survivor’s estate for estate tax purposes, but all of those assets will also receive a further step-up in basis on the survivor’s death. Thus, there will be no built-in capital gains taxes when the children receive their inheritance.

There are, of course many good reasons to still use a trust like the Bypass Trust, even if there is likely to be very little estate tax benefit. First, it offers certainty and some control (i.e., the deceased spouse can be assured that surviving spouse will not change the estate plan to give the assets to persons other than the children, for example). This is quite common in second marriages, where each spouse has children from a prior marriage. Second, the use of a Bypass Trust offers some degree of creditor protection, protecting the deceased spouse’s share of the estate from creditors of the surviving spouse during the surviving spouse’s remaining lifetime.

For some people, these control and creditor protection benefits outweigh the inconvenience and capital gains tax issues that arise from dividing the revocable trust into more than one trust at the first death. Others, however, now prefer to have the survivor retain as much flexibility and control as possible over the entire estate, so that everything passes to the Survivor’s Trust on the first death, now that there is little practical need for estate tax minimization strategies for the vast majority of families.

There is also a strategy that may offer the best of both worlds: preserving most of the control and creditor protection while also receiving a step-up in basis on the Bypass Trust assets at the survivor’s death. This requires granting the survivor a narrowly-crafted “general power of appointment" over the Bypass Trust assets, such as by allowing the surviving spouse a power to appoint those assets by will to the creditors of the survivor’s estate.

What should you do?

If you have not done so recently, you should have your estate plan reviewed by an experienced trusts and estates attorney who can advise you on your options in view of the current law and your particular circumstances. Life brings changes, both in the tax laws, in assets owned, and in relationships to the important people in your life. Changes in any of these areas often mean that it is time to have your estate plan reviewed to make sure that it stays current with you and your preferences and desires.

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