|July 21, 2014|
Previously published on June 26, 2014
The current iteration of the federal estate tax affects well under one percent of the population at death. With the estate tax exclusion now permanently set at $5,000,000 and indexed for inflation, a married couple with a basic estate plan utilizing both spouses’ exclusion amounts would need over $10,680,000 in assets before the punitive federal estate tax bites into a transfer of assets at death.
Only a few years ago, the federal estate tax applied to a much greater percentage of the population. In 2001, the exclusion amount was set at a paltry $675,000 per person, compared to today’s $5,340,000/person. An unmarried decedent with over $675,000 of wealth in 2001 would have paid Uncle Sam an estate tax, ostensibly for the protections the government provided the decedent permitting the decedent the opportunity to build this fortune. Certainly the income taxes collected during the decedent’s life were not enough to satisfy the government!
While the estate tax has become much less of a worry for many people, income tax rates are now higher than they have been in the last decade. Politicians have little motivation to tinker with the current estate tax because it now affects so few of their constituents and generates such a small portion of the government’s revenue. Given this permanency for the current estate tax law, many clients would be well served to consider income tax strategies in their estate plan.
For instance, current income tax law provides for a step-up in tax basis of a decedent’s assets upon death. This means that assets includable in a decedent’s estate receive a new tax basis at the date of the decedent’s death to the fair market value of the asset at the date of death. However, many A/B trusts established over the last 20 years do not fully capture the step-up in basis available to decedents due to the concerns about avoiding the estate tax.
Consider the case of Grandpa Joe and Grandma Betty. Grandpa Joe purchased shares of stock in his brokerage account in 1995 for $200,000 and these shares have grown to $1,000,000. If Grandpa Joe sold these shares while living, he would have a taxable gain of $800,000 and a sizable capital gains income tax. However, if Grandpa Joe retains the shares, upon his death his tax basis in the shares would increase to $1,000,000 and his heirs could sell the shares for $1,000,000 and realize no taxable gain. This is an example of a step-up in basis.
Now consider how this same concept applies to the A/B trusts that Grandpa Joe and Grandma Betty established in 2001. An A/B Trust says that upon the death of the first, the B trust, or the family trust, is funded up to decedent’s federal exclusion amount and the remainder of the trust assets fund the A trust, or the marital trust. The B trust utilizes the decedent’s full exclusion amount and passes those assets estate tax free to the descendants. The A trust is a gift to the surviving spouse and qualifies for the unlimited marital gifting exception. In this manner, both Grandpa Joe and Grandma Betty can fully utilize their estate tax exclusions. However, assets allocated to the B trust only receive a step-up in basis upon the death of the first spouse because they are excluded from the surviving spouse’s estate.
In 2001, the A/B Trust was good planning for a younger Grandpa Joe and Grandma Betty. At that time, Grandpa Joe had a brokerage account worth $1,000,000. Grandma Betty also had a brokerage account worth $500,000, and they owned their residence titled jointly and worth $500,000. If Grandpa Joe had died that year, he would have funded the B Trust with $675,000 from his brokerage account (passing $675,000 to his children estate tax free) and the remaining $325,000 and his half of the house would have been gifted estate tax free to the marital trust for the benefit of Grandma Betty.
Taking this story a step further, a healthy Grandma Betty lived another 13 years. In that time, she utilized all of the marital trust for her lifestyle. Since she was using the marital trust for maintenance, her own brokerage account increased to about $700,000 despite some withdrawals. Her house also increased in value to $700,000. Grandpa Joe’s family trust, which was funded with $675,000, was placed into growth investments and doubled in value to $1,350,000. Upon Grandma Betty’s death in 2014, she has an estate of $1,400,000 ($700,000 brokerage account and $700,000 house) and does not owe any estate tax. However, Grandpa Joe’s family trust has gained $675,000 from the time of his death and this gain does not realize a step-up in tax basis because it is not included in Grandma Betty’s estate. Instead, federal and state income taxes cause a capital gains tax of almost $200,000.
The A/B Trust set-up that was previously good planning for Grandpa Joe and Grandma Betty in 2001 for estate tax purposes has now caused a capital gains income tax of nearly $200,000. If Grandpa Joe had known that the estate tax would no longer be an issue at Grandma Betty’s death, then he could have simply gifted everything to Grandma Betty. She would have died with an estate of $2,750,000 and received a step-up in basis for all assets while still remaining well under the federal estate tax exclusion amount.
Since most people do not have the benefit of being able to predict future laws, building flexibility into these A/B trusts is the key to avoiding the adverse income tax consequences that Grandpa Joe and Grandma Betty experienced. There are several solutions that allow for more flexibility. One is the appointment of a special trustee who has the power to cause assets previously included in the family trust to be included in the surviving spouse’s estate (causing a step-up in basis). This power will only be exercised if the future tax laws allow for a beneficial result. Another solution could be amending and restating an A/B trust into a disclaimer trust. A disclaimer trust funds the marital trust first and allows the surviving spouse the discretion to disclaim property to fund the family trust. The surviving spouse would make the disclaimer depending upon the tax law at that time.
Given the fluidity of the income tax and the estate tax laws in the last decade, it is a good idea to review your current documents and ensure that you have not inadvertently caused an income tax problem by being overly cautious of the estate tax.