Living trusts are the foundation of most estate plans. When they are properly drafted and funded, a Living Trust allows property to pass in a seamless transition to a surviving spouse or other family members without a court-supervised probate and costly legal fees. Living Trusts can also be designed to provide significant tax savings as well as strong asset protection for surviving family members, shielding family assets from claims of future spouses or potential liabilities.
To preserve these benefits and avoid serious legal and tax consequences, Living Trusts drafted prior to 2013, when The American Taxpayer Relief Act of 2012 (ATRA) became law, should be reviewed and modified if necessary, to comply with these new rules.
ATRA significantly impacted all estate planning with ramifications for years to come. Living Trusts that do not conform to the new law may face unfavorable tax results and burdensome administrative costs.
How ATRA changed estate planning
In December 2012 the US was approaching what was widely known as “the fiscal cliff,” which included a potential default on government debt and the expiration of the Bush-era tax cuts. If allowed to expire, all individual estates in excess of $1 million would be subject to estate tax at a rate as high as 55%. The limitation on the exemption amount of $1 million would have impacted a significant number of individuals with retirement savings, equity in real estate, or life insurance policies.
A key goal of estate tax planning has always been to attempt to double the available exemption amount by combining the husband’s exemption with the wife’s. However, this was not a straightforward matter, because under the rules, an individual’s exemption was lost forever upon the death of that spouse.
Michael and Sarah are married and have a total estate of $2 million, with a $1 million individual exemption then in effect. Michael leaves his $1 mil- lion share of their property to his wife Sarah. There is no estate tax on Michael’s death because property left to a surviving spouse is not subject to tax.
However, on Sarah’s subsequent death, her estate is then $2 million ($1 million from Michael and her own $1 million share). Since Michael’s exemption terminated on his death, the tax on Sarah’s death is calculated based on her total estate of $2 million less her $1 million exemption. The result is a taxable estate of $1 million and a federal estate tax of approximately $400,000, based upon a rate of 40%.
Most estate planning avoided this result by creating a Bypass Trust. Rather than have Michael’s share pass directly to Sarah, provisions in their Living Trust instead directed that amount to a Bypass Trust. Sarah would not have full ownership of the funds from Michael but would instead have the right to all income from the Bypass Trust, plus the use of principal for health, education, maintenance, and support. Under IRS regulations, since her use of these funds was limited to these prescribed purposes, on her death, the amount in the Bypass Trust would not be included in her estate and no estate tax would be due. Sarah’s estate would consist only of her original $1 million and not the $1 million from Michael, which went into the Bypass Trust. Since Sarah would have her own $1 million exemption, there would be no taxes on her estate and no taxes on the amount in the Bypass Trust. The effect of this planning with the Bypass Trust was to eliminate the estate tax of $$400,000 on the total combined estate of $2 million.
New Exemption Amount and Portability
ATRA had a significant impact on this planning in two important ways. First, it permanently increased the individual estate tax exemption to $5.25 million (adjusted for inflation). Far fewer people will have estates that are subject to potential estate taxes.
Secondly, ATRA adopted a concept known as “Portability” which combined the estate tax exemptions of a married couple. Without using a Bypass Trust, the surviving spouse is permitted to com- bine each spouse’s exemption for a total of $10.5 million to apply against the total estate value. Now, for example, if Michael leaves his estate of $5.25 million to Sarah, who has a similar estate value, on the death of Sarah, the estate can combine the total exemptions so that the full $10.5 million is not subject to tax. The use of a Bypass Trust no longer increases the available exemption.
Eliminating the Bypass Trust
No Basis Step-Up
If the bypass trust no longer provides estate tax savings should it be eliminated from your Living Trust? Often the answer will be yes. The Bypass Trust may create additional income taxes because property held in the Trust will not receive a step-up in tax basis on the death of the surviving spouse. That means that property in a Bypass Trust, which appreciates in value prior to the death of the surviving spouse, will be subject to capital gains taxes when sold by surviving family members.
Again, in the case of Michael and Sarah, say their combined estate is now $5 million. On Michael’s death, his share is $2.5 million and is allocated to a Bypass Trust. If, by the time of Sarah’s death, the original amount has appreciated to $3.5 million, this increase in value is subject to capital gains taxes on Sarah’s death. With the effective federal capital gains rate now about 22.8 percent, that is $228,000 in federal taxes. If the couple had not used the Bypass Trust, Sarah’s estate would have totaled $6 million and would not have been subject to estate tax. Significantly, the tax basis of all of the property in Sarah’s estate would have been increased to the value on her date of death and that step-up would have eliminated all capital gains taxes.
• If a couple has an estate that will not exceed the total exemption amount of $10.5 million, the Bypass Trust should be eliminated from their planning. This will avoid capital gains taxes on appreciated property and administrative costs associated with the maintenance of the Bypass Trust.
• If family assets currently exceed, or may in the future exceed, the exemption amount of $10.5 million, the Bypass Trust can be useful to protect future asset appreciation from estate taxes. If the calculation is that estate taxes will exceed the capital gains tax on appreciated assets, the Bypass Trust will provide tax savings and should be considered.
• Regardless of the size of the family estate, if part of the estate planning goal is to create liability protection and to protect the value of assets within the family, the Living Trust should be designed so that these features are incorporated into the estate plan while minimizing taxes and administrative costs.
These rules are necessarily broad and certainly will vary based on individual circumstances. Determining current and future estate value is subject to a variety of necessarily imprecise forecasts. Our suggestion, as always, is to discuss all aspects of your planning with an experienced attorney who can evaluate each of the relevant factors to carry out your goals in the most efficient and flexible manner.
Robert J. Mintz, JD LLM, is an attorney and the author of the book “Asset Protection for Physicians and High-Risk Business Owners.” To receive a complimentary copy of the book visit www.rjmintz.com.