In this new era of a significantly increased estate tax exclusion (over $11 million per person) and the option to elect “portability,”[1] the tax concerns of married couples in California have shifted from estate tax avoidance to capital gains tax avoidance. As such, many clients are now considering switching to a less complicated and less administratively burdensome trust to one that leaves all assets to the Surviving Spouse, either outright or in trust, and reduces the capital gains tax exposure.
Before the advent of portability, a couples trust needed to create a Bypass trust (often referred to as a credit shelter trust or tax exemption trust) in order to preserve the Deceased Spouse’s[2] estate tax exemption. Many clients may recall discussions with their estate planning lawyer about what the lawyer referred to as creating an “AB” or “ABC” trusts. Because portability allows the Surviving Spouse to use the Deceased Spouse unused estate tax exemption, the need for a Bypass trust must be reconsidered anew under each clients’ unique situation.
While eliminating the Bypass trust can significantly reduce capital gains taxes on the second death, there are many reasons why a couple may still opt for a Bypass trust. The advantages of keeping the Bypass trust structure are many fold. First, a Bypass trust is irrevocable and therefore safeguards the testamentary intent of the Deceased Spouse. This can be especially important in blended families because each spouse can lock in gifts for their children from a prior marriage. Second, because the GST (Generation Skipping Tax) exemption is not subject to portability a Bypass trust is necessary to protect that exemption should grandchildren be the direct beneficiaries of a Deceased Spouse’s trust. Thirdly, a Bypass trust protects any growth seen by the Bypass trust’s assets from being subject to estate tax upon the death of the Surviving Spouse. Fourth, a Bypass trust that includes a spendthrift provision may protect the Bypass trust assets from the Surviving Spouse’s creditors. And lastly, the Bypass trust allows each spouse to distribute to their children (and grandchildren in limited circumstances) up to $1 million in assessed real property and preserve the parents’ property tax basis. Since this property tax exemption is not portable the Deceased Spouse’s $1 million in exemption is lost with the elimination of the Bypass trust.
A major disadvantage to the Bypass trust is the potential for increased capital gains tax. Upon the first death, the Deceased Spouse’s assets, with certain exceptions, receive a step-up in basis to the market value of the assets as of date of death.[3] The new basis determines the effect of a gain or loss on a later sale of the assets, as well as giving the Surviving Spouse a higher deprecation deduction. In a community property state like California the Deceased Spouse's separate property and all community property asset receives 100% step-up in basis on the first death. When there is a Bypass trust, upon the second death the assets held in the Bypass trust do not receive a second step-up in basis because the assets technically do not belong to the survivor. As such, the appreciation of the assets held in the Bypass trust after the first death will be subject to capital gains tax on any gains realized in a sale after the death of the Surviving Spouse. This may have significant income tax liability for the remainder beneficiaries and may be particularly harsh where liquidation of the assets is required to facilitate the distribution of the assets. While everyone wants to avoid capital gains, it is important to note that these types of trust have their drawbacks in that the trust remains fully revocable by the Surviving Spouse. This means that in a worst-case scenario the Surviving Spouse could remarry and leave the entire estate to the new spouse.
What should couples do? Now is the time to consider whether amending your Trust to a Surviving Spouse’s trust only, or a Surviving Spouse’s trust and marital trust design, would achieve your estate planning goals. For clients whose primary desire is to ensure that their testamentary wishes are not ignored then the Bypass trust is the right vehicle for achieving that goal. For those clients whose primary goal is capital gains avoidance then you may want to amend your trust to accomplish the shifted goal. Clients should have detailed discussions with their estate planning lawyer to determine which approach is right for them.
At Moravec, Varga & Mooney we believe that it’s important to help our clients plan for all of the contingencies. If you would like to discuss amending your Trust or creating a Trust that plans for all such contingencies, please give us a call at 626-460-1763 or send us an email.
[1]Portability allows a Surviving Spouse to use a Deceased Spouse's unused estate tax exclusion. See Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, Pub. L. No. 111-212 (Dec 17, 2010) 124 Stat. 3296, 3302.
[2]The first spouse to die is referred to as the Deceased Spouse with the survivor referred to as the Surviving Spouse.
[3]Exceptions to the step-up include cash, life insurance and income with respect to the decedent’s items.