Do You Still Need Your Trust?

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Money and LockMany trusts were set up to protect wealth from estate taxes when the estate tax exemption was only $600,000. The American Taxpayer Relief Act of 2012 (ATRA12) increased the 2013 exemption to $5.25 million for gifts made this year and the estates of decedents. The exclusion is indexed to inflation and the amount will be $5.34 million in 2014.

Another important aspect of ATRA12 was the decision to make the portability rules for a deceased spouse’s unused estate tax exemption amount permanent. Portability was first introduced in the Tax Relief Act of 2010 as a provision allowing the unused portion of a deceased spouse’s estate and gift tax exemption to be transferred to the surviving spouse. This new “portability” of the unused exemption meant a couple could exclude the first $10,000,000 of their estate without the need for a bypass trust. In order to claim portability, estates must file a timely estate tax return (even if not otherwise obligated to do so) in order to make a portability election and report the amount of the unused exemption that remains from the decedent as a carryover to the surviving spouse. In 2014, the use of portability will allow $10.68 million to be excluded from a married couple’s estate. The Supreme Court’s ruling on the Defense of Marriage Act this year will extend portability to same sex couples who are legally married.

One of the implications of ATRA12 making the new exemption levels permanent is that fewer people risk triggering the estate tax. Some trusts established in years past are no longer needed especially credit shelter trusts. These trusts are often referred to as AB trusts because one trust (an “A” trust) holds assets for the survivor’s use, and the second trust (a “B” trust) sets aside certain assets for heirs. The trust was designed to capture the exemption from the first to die and pass it along to the heirs.

Credit shelter trusts are easy to change when both spouses are still alive, because they are still revocable during that period. When one spouse dies, however, the trusts become irrevocable. That’s when it gets tricky. The Internal Revenue Service’s rules for terminating a trust early are complex. The first course of action is to review your estate plan while both spouses are living and get rid of trusts which are no longer needed.

Many estate plans simply contained testamentary trust provisions in the will to establish the credit shelter trust if needed upon the death of the first spouse. This situation is easily remedied by updating wills. The will could be rewritten without the trust language. Another option provides for a “disclaimer” trust, giving the surviving spouse the option of funding the trust or not. The survivor could decide the estate is never going to be big enough to exceed the exemption amounts and not fund the credit shelter trust. On the other hand, the survivor may want to fund the trust if there are sufficient assets in the survivor’s name and the estate risks being taxed if it grows in the future.

The new tax rates affecting wealthier taxpayers will be the bigger issue when contemplating certain estate planning strategies. Grantor trusts may be counterproductive for some families because the grantor pays the tax at the new tax rates. It will be important to review these trusts especially if the beneficiaries are in a lower tax bracket. It may make sense to terminate these trusts and make distributions to beneficiaries. Such planning would take advantage of the beneficiaries’ lower brackets, but the purpose of the trust should be reviewed.

Taxpayers residing in states retaining an estate and/or inheritance tax will need to consider the state laws before removing trust provisions. The step-up in cost basis for appreciated assets has been retained in ATRA12. In some cases paying the state inheritance tax in order for the heirs to step-up their cost basis and avoid capital gains tax is going to be the most cost effective option. The effect of the increase in capital gains tax should be considered when deciding to make gifts of appreciated assets. There is no step-up in basis for assets gifted during lifetime. Assets transferred by gift retain the donor’s basis except if the asset value on the date of gift is less than the donor’s cost. A little known rule gives the beneficiary a split basis, which prevents the beneficiary from realizing the loss on the sale of the asset.

Trusts are easy to unwind if they are still revocable or haven’t been funded. Make it a priority this year to review your estate plan and eliminate trusts that are no longer needed.

Rick’s Tips:

  • The American Taxpayer Relief Act of 2012 increased the 2013 estate tax exemption to $5.25 million for gifts made this year and the estates of decedents.
  • In 2014, the use of the new portability provision will allow $10.68 million to be excluded from a married couple’s estate.
  • Credit shelter trusts are easy to change when both spouses are still alive, because they still are revocable during that period.

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