First, the past estate tax situation:
For many years, the basic estate planning document has been the A-B (or A-B-C) revocable trust, and the basic goal has been to exclude assets from the taxable estate in order to reduce the value of the estate down to the exemption amount so that no estate tax is due.
Because of recent changes in the law this may no longer be the best model.
Let’s take a look at this old standby and see if it’s still valid.
Just what is an A-B (-C) revocable trust?
As the per-person estate tax exemption increased from $600,000 in 1997 to $3,500,000 in 2009, there were two objectives for the estate plan of most married couples:
- First, to reduce estate tax to zero on the death of the first spouse, leaving the maximum assets available to support the surviving spouse.
- Second, to avoid as much appreciation in the estate as possible from being taxed on the surviving spouse’s death.
Thus, the A-B trust was born.
In the A-B Trust, the A trust (frequently known as the Survivor’s Trust) holds the surviving spouse’s portion of the couple’s estate.
In community property states, such as California, in general separate property consists of anything received by gift or inheritance, and anything earned prior to the marriage. Community property consists of all the earnings or proceeds of the earnings of the couple during the marriage. Each spouse is the owner of an undivided one-half interest in the community property. In California, then, the Survivor’s Trust consists of the surviving spouse’s separate property and her one-half of community property.
(To simplify the discussion, I will refer to the first spouse to die as “him,” and the surviving spouse as “her,” since statistically wives outlive husbands, and “he or she” and “him or her” interrupt the flow of the text. Keep in mind that the wife can be the first spouse to die and the husband the survivor just as well.)
Since the Survivor’s Trust consists of the surviving spouse’s own property, she has the right to do with it whatever she wishes, including leaving it to whomever she wants, after her husband dies.
As bequests to a spouse are exempt from estate tax (the “marital deduction”), the surviving spouse also received the “marital deduction amount.” The marital deduction amount was calculated to equal to the exact amount of the first spouse to die’s portion of the estate necessary to reduce the estate tax to zero.
Before 1981, to qualify for the marital deduction, a bequest had to be given outright to the surviving spouse or to a Survivor’s Trust for her benefit. At that time, qualification for the marital deduction required that the surviving spouse had to have all income from the marital deduction property and the right to control the disposition of the marital deduction property on her death.
The B trust (frequently referred to as the Residual, Credit Shelter, or Bypass Trust) consisted – and still consists – of the amount of the first-to-die spouse’s share of the estate equal to the estate tax exemption amount.
Enter the QTIP:
After the Estate Tax Reform Act of 1981, a new category of property was created: Qualified Terminable Interest Property (QTIP).
QTIP qualified for the marital deduction, just as before, if the surviving spouse got all the income from the property, but now the disposition of the property on her death could be fixed in advance. (This was added to protect the children of first marriages from being cut out of the estate by a second spouse – reportedly at the insistence of the divorced President Reagan and his much-divorced Hollywood friends.)
Thus, the C Trust (frequently known as the QTIP or Marital Trust) was born.
The Marital Trust held the amount of the husband’s property in excess of the exemption amount. As noted above, the Marital Trust paid all its income to the surviving spouse, but its final disposition was predetermined.
(Marital Trusts can, and many do, provide the wife with additional rights to invade the principal of the trust for her maintenance and support, and/or some flexibility in determining the final distribution of assets, but they don’t have to, and yet they still will qualify for the martial deduction.)
Here’s an example to illustrate how this worked:
A married couple had a combined estate of $10,000,000, consisting of all community property. The husband died in 2009.
Here’s how the trusts would be funded:
Survivor’s Trust: $5,000,000 (the wife’s half of community property)
Bypass Trust: $3,500,000 (the husband’s exemption amount)
Marital Trust $1,500,000 (the amount necessary to reduce the estate tax on the husband’s death to zero)
As part of the deal creating QTIP, at the second death the surviving spouse’s estate would be taxed on the total of the amount remaining in the Survivor’s Trust and the amount in the Marital Trust.
And here’s the important benefit of a Bypass Trust — it is not subject to estate tax when the surviving spouse dies.
If fact, if properly structured, it can pass down two generations (to your grandchildren!) without being subject to estate taxes – no matter how large it grows. So if the trustee was astute enough to pick the next Microsoft or Beverly Center, the Bypass Trust could be worth a billion dollars at the death of the surviving spouse, and it still would not be subject to estate tax!
The step-up in basis:
Of course, there’s a price to be paid for this benefit, and the price is something called the “step-up in basis.”
When you sell any type of property, be it real estate, stock, artwork, a car, or anything else, you must pay income tax (generally capital gains) on the difference between what you bought it for (the basis) and what you sold it for. If you bought stock for $100 in 1980 and sold it for $250 in 2009, you have $150 of gain to report on your income tax return.
But, the basis of inherited property is “stepped-up”to its fair market value at the date of death. So if you inherited the property when it was worth $250, and sold it when it was worth $250, you had zero gain and therefore paid no income tax.
At the death of the first spouse to die, this step-up in basis applies to the property in the Bypass Trust, but not to the property in the Survivor’s and Marital Trust, because that property hasn’t left the estate of the surviving spouse yet.
At the time of the surviving spouse’s death, the assets of the Survivor’s Trust and the Marital Trust do receive a step-up in basis to their then-current fair market value, because they were included in the surviving spouse’s estate — but there is no step-up in basis for the Bypass Trust, because it wasn’t included (remember, it escapes estate tax at the second death).
Especially in the Bush-era tax years, when capital gains taxes were only 15%, and estate tax rates were as high as 49%, paying 15% tax on the increase in value of an asset was a much better deal.
— Published April 2014
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