Update Your Living Trust And Will

This article is reprinted from my friend and asset protection attorney Jacob Stein of Kleuger & Stein, LLP.

On December 16, 2010, Congress passed and sent to the President the “Middle Class Tax Relief Act of 2010.” The law contains the most sweeping change in the taxation of estates in 29 years. It also contains a ticking time bomb that might explode in the faces of the beneficiaries of many trusts. As a result of the new law, many existing estate plans no longer work, and many others will cause actual harm. As a result, every married couple’s existing estate plan should at least be reviewed, if not scrapped.

Here are the major estate tax changes:

The exclusion from estate tax for citizens and residents is increased to $5 million. If a person dies with an estate under valued at under $5 million, his or her estate pays no estate tax. The $5 million exclusion will increase based on cost-of-living adjustments. The exclusion was $3.5 million in 2009.

If a decedent’s estate exceeds $5 million, the rate of tax on the excess is reduced to 35%. The highest rate was 45% in 2009.

A married couple can shield $10 million from estate taxes. If the first to die of a married couple (the “deceased spouse”) does not use his or her $5 million exclusion, the administrator of the deceased spouse may elect to give the unused exclusion to the surviving spouse.

It is this last change, the “portability” of unused estate tax exclusions, that will cause many estate planners – and their clients – to question the viability of their existing estate plans.

In order to understand the problem, we must focus on a basic estate tax concept, the “unlimited marital deduction” (“UMD”). With a couple of minor exceptions beyond the scope of this article, if a person dies and leaves his or her estate to his or her surviving spouse, the UMD says that there are no estate taxes on the first death, regardless of the size of the estate. No fancy estate planning is required in order to qualify for the UMD. For example, were Bill Gates to write a one-sentence will on the back of an envelope saying “I give everything to my wife when I die,” the UMD would kick in, resulting in his widow receiving the entire estate free of estate taxes. The theory behind the UMD is that married couples should be treated as a unit, with estate tax coming due only on the death of the surviving spouse.

The interplay of the exclusion and the UMD resulted in married couples losing one estate tax exclusion. Let’s assume Mr. and Mrs. Jones, a married couple with a $7 million estate. If Mr. Jones had died in 2009, when the exclusion was $3.5 million, leaving everything to Mrs. Jones, the UMD results in no estate taxes on Mr. Jones’ death. If Mrs. Jones had also died in 2009, the IRS would have allowed a $3.5 million exclusion to Mrs. Jones’ estate, and would have taxed everything above $3.5 million, resulting in a estate tax of $1,455,800. If Mr. and Mrs. Jones had never met and never married, and each had died in 2009 with a $3.5 million estate, the combined estate tax would have been zero!

For many years, the IRS has allowed married couples to avoid this result by means of a trust that, unlike Bill Gates’ hypothetical one-sentence will, does require some fairly sophisticated estate planning. The planning device is an “A-B” trust, and it operates as follows: Let’s assume that Mr. and Mrs. Jones’ estate is valued at $7.1 million, and that Mr. Jones died in 2009, when the exclusion was $3.5 million. Upon his death, the estate divides into two sub-trusts, a “Marital Deduction Trust,” [the “A” trust] and a “Credit Shelter Trust” [the “B” Trust.] The “B” Trust is allocated an amount equal to the exemption in effect in the year of the deceased spouse’s death ($3.5 million). The “A” Trust is allocated the balance, i.e. $3,600,000. On Mr. Jones’ death, the Marital Deduction Trust is not subject to estate tax because it qualifies for the UMD. The “B” Trust is subject to estate tax, but the assets allocated to it equal Mr. Jones’ exemption, resulting in no tax. So far, we have not done anything to avoid estate taxes for Mr. Jones or Mrs. Jones; a one-sentence will leaving everything to Mrs. Jones would have sufficed to completely avoid estate taxes on Mr. Jones’ death.

The magic that is the A-B trust becomes apparent on the second death. Let’s assume Mrs. Jones also died in 2009. The $3.6 million in the “A” trust is subject to tax, Mrs. Jones gets her $3.5 million exemption, and only $100,000 is subject to tax. None of the assets in the “B” trust are subject to tax.

In order for the A-B technique to work, the “B” Trust must restrict Mrs. Jones’ use of the property. She may not have a “general power of appointment” over the property, i.e. the unfettered right to dispose of the property. Usually, her power to invade the trust is limited to Mrs. Jones’ “health, education, support and maintenance” needs, which shouldn’t cramp her style, but is less than the complete discretion she has over the “A” Trust. Not having a general power of appointment over the assets means that she is deemed not to own the assets, and if she is deemed not to own them, her estate is not taxed on them.

All this will be unnecessary on January 1, 2011. Starting then, Mr. Jones’ executor will be able to give Mr. Jones’ unused $5 million exemption to Mrs. Jones, even with a one-sentence will written on the back of an envelope. The potential problem lies in those “A-B” trusts that pre-date the new law, and the problem is not an estate tax issue; it’s an income tax issue.

One of the biggest benefits of the Internal Revenue Code is the “step-up” in basis when a person dies. For example, had Mr. Jones bought Ford Motor Company stock for $10 per share, and sold it during his lifetime for $100 per share, he would have realized a $90 capital gain. But if Mrs. Jones had inherited the stock from Mr. Jones, she would have obtained a $100 date-of-death basis in the stock, and all of the gain inherent in the stock would have been forgiven. Had she later sold the stock for $101, her capital gain would have been $1, not $91. But in order to obtain a step-up, the asset must be included in a decedent’s estate, and none of the assets in the “B” trust are included in the decedent’s estate. In our example, if the Ford stock had increased in value from $100 to $300 following Mr. Jones’ death, their children would receive a $100 basis in the stock, not $300.

In prior years, we weren’t much troubled by this result. We were willing to forego the step-up in basis in order to avoid the estate tax, because estate tax rates were always higher (45%) than capital gains rates (15%). But with a married couple now able to shield a $10 million estate from estate taxes without an A-B trust, any married couple with an estate small enough so as to likely not incur an estate tax will now find that their “B” trust is an income tax albatross. These married couples will lose the basis step-up, with all of the resulting capital gains taxes, without any corresponding estate tax savings.

In addition to the tax detriment that is inherent in the A-B trust, there is a non-tax reason that many existing A-B trusts may now no longer meet their creators’ needs. In order to qualify for the estate tax benefits of the A-B trust, the tax code instructed us how to write those trusts. Specifically, following the first spouse’s death, the surviving spouse may freely alter or amend the “A” trust, the “B” trust becomes irrevocable following the first spouse’s death. Many people were willing to suffer this consequence if it meant a substantial reduction – or elimination – of estate taxes. But for married couples with an estate that is not likely to reach $10 million, this consequence may no longer be acceptable.

There are some circumstances when a “B” trust may be desirable for non-tax reasons, and those still remain intact. For example, the first-to-die spouse may want some assets to be placed in an irrevocable trust to make certain that the children receive those assets, and not the survivor’s new love interest.

Bottom line: Any married couple with an “A-B” trust should, at the very least, have it reviewed. Depending on the size of the estate and the nature of the assets, many married couples will wish to amend or revoke their existing estate plans.