The gold standard for spouses preparing a Revocable Living Trust after 1981 was what has generally become known as the AB or ABC Trust. That allowed each spouse to take advantage of the Exemption Equivalent Amount from Federal Estate Taxes.
Starting in 1981, that Exemption Equivalent was going to slowly work its way up to $600,000. In 1997, that was going to then ramp the $600,000 Exemption up to $1 million over a ten (10) year period of time. The Bush Tax Cuts initiated in 2001 were going to phase the Exemption from $1 million to $5 million by 2010 and then were going to “sunset” back to $1 million on January 1, 2011.
That compelled Estate Planners to advise their married clients to each take advantage of the Exemption Equivalent by creating a Trust that provides that after the first spouse dies, their one-half (½) of the community property and all of their separate property would be distributed to generally what is known as a Bypass Trust, and the surviving spouse’s one-half (½) of the community property and separate property would be distributed to the Survivor’s Trust.
The deceased spouse’s Bypass Trust became irrevocable upon the first spouse’s death, and the surviving spouse’s one-half (½) could still be amended by the surviving spouse during her/his life.
Upon the surviving spouse’s death, the contents of the Bypass Trust, no matter what they had grown to during the surviving spouse’s life, would not be included in the taxable Estate of the surviving spouse. Since 1981, literally millions of American couples have created AB or ABC Trusts. Many of those Bypass Trusts have become irrevocable upon the first spouse’s death.
The American Taxpayer Relief Act of 2012 eliminated the need for most couples to do an AB or ABC Trust, as Portability was introduced for the first time. Portability provides that when the first spouse dies, their Exemption Equivalent is portable to the surviving spouse. In 2013, the Exemption for Federal Estate Taxes was $5.25 million, and that increased to $5.39 million, $5.43 million and $5.45 million. Portability was expanded with the 2017 Tax Reform Act which increased the Exemption Equivalent to $11.18 million per spouse for 2018 and $11.4 million for 2019.
What we are seeing is that most clients who have lost their spouse took assets that had the greatest opportunity for growth and appreciation and placed them in the Bypass Trust, taking the assets with the least opportunity for growth and appreciation and placed them into the surviving spouse’s Trust, in order to “freeze” the surviving spouse’s taxable estate.
Now that we have Portability and an Exemption Equivalent of $11.4 million, spouses who are managing their deceased spouse’s Bypass Trust have an important consideration: huge unrealized capital gains in the deceased spouse’s Bypass Trust that will not receive a step-up in basis after the surviving spouse dies.
Consider the following example:
George died in 2008. His one-half (½) of the Estate was $1 million. It was placed into the Bypass Trust. Lavonne’s one-half (½) of the Estate, $1 million , was placed into the Survivor’s Trust. George’s Trust became irrevocable upon his death. In the ten (10) years that have passed since his death, the assets of his Bypass Trust have increased in value to $2 million, generating $1 million in unrealized gain. Upon Lavonne’s death, the contents of both George’s Bypass Trust and Lavonne’s Survivor’s Trust will pass to their four (4) children. Lavonne’s Survivor’s Trust’s assets will receive a step-up in basis to the date of her death value, washing all capital gains away. Unfortunately, the assets in George’s Trust will not receive a step-up in basis upon Lavonne’s death, passing $1 million in unrealized capital gains to the four (4) children, or $250,000.00 in capital gains to each of them. As their capital gains rate will be twenty percent (20%) Federal and 12.2% State, each of the children will have a capital gains tax due of $80,500.00 for a total of $322,000.00 in State and Federal Capital Gains Taxes upon receiving the contents of George’s Bypass Trust upon their mother’s death.
What alternatives do we have available?
Some Bypass Trusts provide that the Trustee (surviving spouse) can pay the surviving spouse all of the net income from the Bypass Trust and as much of the principal as the Trustee, in the Trustee’s absolute discretion, deems appropriate for the surviving spouse’s life, the entire contents of the Bypass Trust could be distributed to the surviving spouse by way of her Survivor’s Trust, which remains subject to her revocation or amendment during the balance of her life. Since George’s Trust cannot be amended after his death, distributing the contents of the Bypass Trust to the surviving spouse’s Revocable Trust would require the written consent of all four (4) children. The reason for that is that if the contents of George’s Trust are distributed to their mother, and their mother can amend the Survivor’s Trust during her life, they are going to have to be nice to their mom for the rest of her life, because now can she not only amend her Survivor’s Trust, but she can also essentially amend their father’s Bypass Trust when all of those assets from the Bypass Trust are distributed to the Survivor’s Trust.
In most cases, it is advisable to seek the Probate Court’s approval of a distribution of the contents of the Bypass Trust to the Survivor’s Trust to minimize any claim by the children after Mom dies that she denied them access to what would otherwise have passed to them through their father’s Bypass Trust. In the case of a blended family, where Lavonne had two (2) children and George had two (2) children, and George wanted to provide for Lavonne for life and upon her death to his two (2) children, and Lavonne wanted to provide for George for life and upon his death to her two (2) children, terminating the Bypass Trust would not be appropriate under those circumstances. We would want to honor the wishes of the deceased spouse and protect George’s two (2) children from Lavonne amending her Survivor’s Trust and excluding them.
But when both spouses have the same testamentary intentions and the same children, there would be no benefit in keeping the Bypass Trust in existence, trapping those capital gains for the children to ultimately pay huge taxes on after the second parent dies. Since the Exemption Equivalent is now $11.4 million, if the combined contents of the Bypass Trust and Survivor’s Trust are significantly less than $11.4 million, there would be zero estate tax reason to keep the Bypass Trust and huge capital gains tax reasons to terminate it.
The other benefit is that Lavonne has been filing a separate Income Tax Return (IRS Form 1041) every year on George’s Bypass Trust and a 1040 on her Survivor’s Trust. If the contents of the Bypass Trust are distributed to the Survivor’s Trust, she can file one final Form 1040 for George’s Trust and then just continue to file one (1) Form 1040 for the balance of her life.
If you or someone you know has lost their spouse and has distributed the deceased spouse’s share to the Bypass Trust, and there are significant capital gains in that Bypass Trust and their total combined Estate is less than $11.4 million, we need to talk.
Written by Mark S. Drobny and most recently updated January 30, 2019.