News & Commentary

A couple’s revocable living trust can be freely amended during their joint lifetimes.  Amendments can be used to adapt to changes in law, family circumstances, or the couple’s wishes.  However, once the first spouse passes away, a revocable living trust usually becomes wholly or partly irrevocable and cannot be easily fixed or modified.  Therefore, it must be frequently reviewed and maintained to ensure it achieves its intended purpose.

The American Taxpayer Relief Act of 2012 (the “Act”) was enacted in January of 2013. The biggest change brought about by the Act was an increase in the individual estate tax exemption amount.  While California does not have an estate tax or death tax, California residents are subject to federal estate taxes on death for assets above and beyond a threshold amount.  This threshold amount is commonly referred to as the individual estate tax exemption amount (the “Exemption Amount”).

In recent years, the Exemption Amount has been dramatically increased.  In 2005, the Exemption Amount was $1.5 million and, in 2008, it was $2 million. The current Exemption Amount, brought about by the Act, is $5.49 million for each individual, adjusted annually for inflation. Further, any unused estate tax exemption amount by a deceased spouse is “portable” to the surviving spouse, provided a timely “portability election” is made. Therefore, a surviving spouse may be able to add his or her deceased spouse’s exemption amount to his or her own exemption amount, giving him or her an exemption amount of $10.98 million at death.

As a result of these changes, estate taxes are no longer a concern for most estates and the complexity of an AB Trust is no longer necessary to avoid them.  Also, an AB Trust may carry negative tax consequences.

Your Estate Plan May be More Complex Than Necessary

Prior to 2013, when the estate tax exemption amount was much lower, attorneys wisely advised their clients to execute a certain type of revocable living trust called an “AB Trust.”  Under an AB Trust, when the first spouse passes away, the trust property is divided and the survivor’s assets are allocated to a survivor’s trust (the “A” Trust) and the decedent’s assets are allocated to a decedent’s trust (the “B” Trust).  The decedent’s trust is irrevocable, and the survivor’s trust is revocable. Since portability of the deceased spouse’s Exemption Amount was not available, the AB Trust was used to ensure that the couple received “full credit” for the deceased spouse’s exemption amount. Here's an illustration:

Couple with AB Trust Avoids Estate Tax in 2005

• January 1, 2005
  Husband and Wife create an AB Trust and fund it with their community property family home worth $3 million.
  
• July 1, 2005
  Husband dies and, pursuant to the terms of the AB Trust, the family home is allocated to the decedent’s trust (50%) and the survivor’s trust (50%).  Though Wife likely has income rights to the decedent’s trust (a right to reside in the family home rent-free), it is not considered part of her estate under trust law.  Therefore, the decedent’s trust allows Husband to use his Exemption Amount ($1.5 million in 2005) to the pass 50% of the family home, worth $1.5 million, to his beneficiaries estate tax-free.
• December 1, 2005
  Wife dies and the survivor’s trust allows her to use her Exemption Amount ($1.5 million in 2005) to pass the other 50% of the family home, worth $1.5 million, to her beneficiaries estate tax-free.

Same Couple without AB Trust Incurs (Substantial) Estate Tax in 2005

• January 1, 2005 
  Husband and Wife create a living trust that will remain revocable after the first spouse’s death and will not require sub-trust funding after the first spouse’s death.  They fund it with their community property family home worth $3 million.
• July 1, 2005
  Husband dies and his interest in the family home (50%) remains in the revocable trust and passes to Wife.  In 2005, there is no benefit of portability, so Husband’s unused Exemption Amount vanishes.
• December 1, 2005
  Wife dies and the trust allows her to use her Exemption Amount ($1.5 million in 2005) to pass 50% of the family home, worth $1.5 million, to her beneficiaries estate tax-free.  The other 50% interest of the family home, worth $1.5 million, will be subject to federal estate taxes at a rate of 47%.  Thus, the estate owes $705,000 to the IRS!

In 2005, the couple with the AB Trust would have incurred expenses of administration.  Working with attorneys, CPAs, and appraisers may have been a legitimate burden to a grieving surviving spouse, but it was worth it!

Today, the burdens of the AB Trust may no longer be desirable because of the high Exemption Amount and the benefit of portability under the Act.  You may now be able to simplify your revocable living trust by removing unnecessary administrative burden.

Your Estate Plan May Carry Negative Tax Consequences

In California, most community property assets receive a “step up” in tax basis at the death of the first spouse. This means that when a surviving spouse sells an asset, the base value used to determine capital gains tax is the value of the asset on the first spouse’s death, not the date the asset was purchased. For example, husband and wife purchase a home for $500,000.00, and on husband’s death the home is valued at $750,000. Wife later sells the home for $1 million. Wife will pay capital gains tax on $250,000 ($1,000,000 minus $750,000). This rationale also applies to beneficiaries of an estate. In the above example, imagine Wife dies and the home is valued at $1 million at her date of death.  If the beneficiaries sell the home for $1 million, they pay no capital gains tax because the value of the home received a “step up” in tax basis to its value on the date of wife’s death. 

In comparison, if you have an AB Trust, assets of the first spouse to die (transferred to the decedent’s trust) will NOT receive a “step up” in tax basis upon the surviving spouse’s death.  If the remainder beneficiaries (usually the couple’s children) decide to sell the assets in the decedent’s trust, they will incur capital gains tax on the difference between the value of assets when they were transferred to the decedent’s trust and the value of the assets when sold.  Here's another Illustration:

Beneficiaries of AB Trust Incur Capital Gains Tax

• January 1, 2015
  Husband and Wife create an AB Trust and fund it with their community property family home worth $3 million.
• February 1, 2015
  Husband dies and, pursuant to the terms of the AB Trust, the family home is allocated to the decedent’s trust (50%) and the survivor’s trust (50%).
• July 1, 2020
  Wife dies and at the time of her death the family home is worth $5 million.  The beneficiaries receive 50% of the family home from the survivor’s trust with a tax basis of $2.5 million because of the “step-up” at Wife’s date of death.  However, the tax basis is only $1.5 million for the 50% of the family home that the beneficiaries receive from the decedent’s home, because there is no “step-up” at Wife’s date of death.  Thus, the overall tax basis of the family home is $4 million.
• January 1, 2021
  The beneficiaries sell the family home for $5 million.  They are subject to capital gains taxes on their $1 million gain (difference between sale price and tax basis). The effective capital gains tax rate in California can be as high as 37%, meaning that under this scenario, the AB Trust would unnecessarily cause $370,000 in capital gains taxes.

Consider using a Disclaimer Trust rather than a Bypass Trust

You and your spouse may be able to avoid these administrative burdens and negative tax consequences of an AB Trust by amending and restating your revocable living trust and possibly converting it to a “disclaimer trust.” A disclaimer trust gives the surviving spouse the option to disclaim assets of the deceased spouse, in which case they would automatically be transferred to a decedent’s trust, or to keep all assets of the deceased spouse, in which case they would be transferred to a survivor’s trust.  A disclaimer trust does not carry the administrative burdens that an AB Trust does – e.g., upon the death of the first spouse, the surviving spouse does not need to establish and fund a decedent’s trust unless there is a tax planning or asset protection reason for doing so. Furthermore, when a disclaimer trust is used, all assets that pass to the survivor’s trust will receive a “step up” in basis on the death of the surviving spouse. 

Consider using a QTIP Trust rather than a Bypass Trust 

In some cases, an AB Trust structure is the best approach.  Especially when planning for blended families and when asset protection is desirable.  An AB Trust will ensure one’s spouse does not disinherit children from a prior marriage after the parent’s death. There are a number of reasons why an estate plan might benefit from asset protection, a family history of dementia, business interests with a high degree of liability, or frequent use of caretakers.  An AB Trust can provide asset protection for a large portion of the trust assets after the first spouse’s death. 

If an AB Trust structure is desirable, you should consider using another type of irrevocable trust, a qualified terminable interest property (“QTIP”) trust, rather than a bypass trust.  A QTIP trust has similar attributes to the bypass trust. For example:

Prior to 2013, bypass trusts were commonly found in AB Trusts. Since assets funded to a bypass trust are considered part of the deceased spouse’s estate, the bypass trust ensured that the Exemption Amount of the deceased spouse could be utilized.  As discussed above, this often results in negative tax consequences.

As a result of portability, there is no longer a need to utilize the Exemption Amount of the deceased spouse when the deceased spouse dies.  A key difference between a QTIP trust and a bypass trust is that the QTIP trust is considered part of the surviving spouse’s estate – even though the surviving spouse has limited rights to the assets held by the QTIP trust. Since the QTIP trust is considered part of the surviving spouse’s estate, assets held by the QTIP trust receive a “step-up” in tax basis to fair market value at the surviving spouse’s death..

The administrative burden of a QTIP trust is similar to a bypass trust. However, if you desire the asset protection of an AB Trust regardless of the administrative burden – because you have a blended family or for some other reason – a QTIP Trust can achieve your goals while also eliminating the negative tax consequences discussed above.

In conclusion, if your estate plan was prepared before 2013 you should have it reviewed.  A simple amendment may help avoid unnecessary administrative burdens and negative tax consequences.  As always, please do not hesitate to call our offices if you have any questions or to schedule a review of your estate plan.

- The Estate Planning Law Team
  Rogers Sheffield & Campbell, LLP

This article is not intended to provide legal advice. For legal advice on any of the information in this post, please contact us directly, use the form to the right or contact us by phone at 805-963-9721.