The American Taxpayer Relief Act of 2012 (ATRA) averted the so-called “fiscal cliff” and was signed into law by President Obama on January 2, 2013. While most of the attention was directed at ATRA’s impact on Income Taxes and Capital Gains Taxes, the impact on Estate Planning as we go forward is monumental. Not since the Economic Recovery Tax Act of 1981 (ERTA) has a single piece of tax legislation had such far reaching implications on all of our clients’ needs to look at their current Estate Plans.
Beginning with the Economic Recovery Tax Act of 1981 (ERTA), the gold standard for Estate Planning for married couples was the so-called “AB” Trust or “ABC” Trust. ERTA gradually increased the Exemption Equivalent to $600,000 by the mid-1980’s. For the first time, it created the Unlimited Marital Deduction.
Example: John and Mary had a $1.2 million Estate. John died in 1996 and his one-half (½) of the community property could pass to Mary free from Federal Estate Taxes by virtue of the Unlimited Marital Deduction. Upon Mary’s death, both halves of the community property ($1.2 million) are included in her Taxable Estate. As the Exemption was $600,000 in 1996, the $600,000 she inherited from John would be taxed at 45%, or $270,000. The alternative would be for John and Mary to create an AB Trust. Upon John’s death, his $600,000 would be distributed to his Bypass Trust. Since the first $600,000 in his Estate is exempt from Estate Taxes, there would be no Estate Tax upon his death. Mary would be the Trustee and beneficiary of John’s Trust for life. When Mary dies, only her $600,000 would be includable in her taxable Estate, generating zero Estate Taxes after both deaths, saving their children $270,000.
One additional benefit of doing an AB Trust would be to honor the testamentary intentions of the first spouse to die, preventing the surviving spouse from changing the predeceased spouse’s testamentary intentions. She could only change her portion of the Trust, not his.
Another benefit of the AB Trust was Asset Protection. Should the surviving spouse become involved in a liability causing event after the first spouse dies, only the surviving spouse’s share of the Estate would be subject to any claims.
The so-called Bush Tax Cuts enacted in 2001 increased the Exemption Equivalent from the previous $600,000 to $1 million for persons dying in 2002 and 2003; $1.5 million for persons dying in 2004 and 2005; $2 million for persons dying in 2006, 2007 and 2008; $3.5 million for persons dying in 2009; and, $0 Estate Tax for persons dying in 2010. The Bush Tax Cuts were to “sunset” on January 1, 2011, bringing the Exemption Equivalent back to $1 million. That first “fiscal cliff” was averted with an extension until December 31, 2012, when we were to be looking at the Exemption Equivalent falling back to $1 million for persons dying after December 31, 2012.
This on-going uncertainty as to what the Exemption Equivalent amount would be in the year of our clients’ deaths led experienced Estate Planning Attorneys to continue to recommend an AB Trust even when a client’s Estate was valued under $5 million because of the threat of the Exemption Equivalent dropping back to $1 million on January 1, 2011 and again on January 1, 2013.
Additional benefits of the AB Trust were Asset Protection. Nothing in the Deceased Spouse’s Bypass Trust was subject to any claim against the surviving spouse, however, adequate homeowner’s insurance, automobile insurance and an umbrella policy adequately address most concerns.
The downside of the AB Trust has always included:
- Having to prepare an Allocation Agreement after the first spouse died, listing and valuing all of the assets in the Trust and then deciding which assets go into the deceased spouse’s Bypass Trust and which assets go into the surviving spouse’s Trust. This required substantial appraisal, attorneys and accounting fees;
- The surviving spouse being unable to amend the deceased spouse’s share of the Trust irrespective of what happens to the family or estate after the first death;
- Filing a Fiduciary Income Tax Return (IRS Form 1041) on the deceased spouse’s Bypass Trust each year for the duration of the surviving spouse’s life in addition to filing an Individual Income Tax Return (IRS Form 1040);
- Not receiving a step-up in basis on the Bypass Trust assets when the surviving spouse dies; and,
- Having to provide any beneficiary named in the predeceased spouse’s Bypass Trust a copy of the Trust and a detailed (balanced to the penny) annual accounting.
Estate and Gift Taxes
The Exemption for Federal Estate and Gift Taxes for 2011 was $5 million and was $5.12 million for persons dying in 2012. The “fiscal cliff” was going to cause that Exemption Equivalent amount to drop to $1 million effective January 1, 2013. ATRA has now increased that amount to $5.34 million for 2014, $5.43 million in 2015, $5.45 million in 2016 and $5.49 million in 2017, and is “permanent” to be adjusted annually upward for inflation each year. The 2017 Tax Act increased the Exemption Equivalent to $11.2 million for persons dying in 2018. Gifts or transfers at death in excess of the Exemption Equivalent amount will be taxed at 40% (as opposed to 35% in previous years). ATRA made “portability” of a deceased spouse’s unused Estate Tax Exemption permanent if made in a timely election after the death of the first spouse to die. Essentially, this allows the surviving spouse to use the Deceased Spouse’s Unused Exempt Amount (DSUEA) for gift or Estate Tax purposes.
Example: John dies in 2017 with an Estate of $2 million. His Exemption Equivalent amount is $5.49 million. If no bypass trust is created, all of John’s assets are transferred to Mary. If Mary files a Federal Estate Tax return (IRS Form 706) within nine (9) months of his death, John’s $5.49 million DSUEA is portable to her and the first $5.49 million that she gives away during life or at death is not subject to Estate or Gift Taxes in addition to her own $5.49 million Exemption.
Example: John dies in 2017 with an Estate of $2 million. His Exemption Equivalent amount is $5.49 million. He and Mary had an AB Trust. John’s $2 million is transferred to his bypass trust. John’s DSUEA is $3.49 million. If Mary files a Federal Estate Tax return (IRS Form 706) within nine (9) months of his death, John’s $3.49 million DSUEA is portable to her and the first $3.49 million that she gives away during life or at death is not subject to Estate or Gift Taxes in addition to her own $5.49 million Exemption.
We now need to ask our clients whether they still need an AB Trust, especially with Portability, the DSUEA and an $11.2 million Exemption per spouse.
Do you want to go through the hassle of the appraisal, legal and accounting fees associated with an Allocation Agreement, the separate income tax returns, losing the step-up in basis on the deceased spouse’s Bypass Trust assets after the surviving spouse dies and giving an annual accounting to anyone named in your deceased spouse’s Trust every single year for the rest of your life? Privacy is another concern with an AB or ABC Trust. Everyone named in the Trust is entitled to a copy of the Trust after the first spouse’s death. To make matters worse, recent California case law provides that anyone who is entitled to anything from the Trust after the second spouse’s death is entitled to an accounting balanced to the penny every single year after the first spouse’s death. The only reasons you would want to consider keeping an AB or ABC Trust are:
- To preserve the deceased spouse’s testamentary intentions. If we are dealing with a blended family, making sure that “when I die and my wife dies, my kids get my share” or “if I die, and my husband remarries, I don’t want everything going to his new wife” are issues, then the AB Trust might still make sense; or,
- If Asset Protection is a concern, having the predeceased spouse’s portion of the Estate transferred to an Irrevocable Trust after the death would protect that one-half (½) of the Estate from any claims against the surviving spouse. Good automobile and homeowners policies coupled with an umbrella policy of at least $1 million should address this concern in most cases.
Conclusion: The gold standard for Estate Planning for married couples from 1981 to 2012 was the AB or ABC Trust. For married couples where there is no blended family, where there is no separate property, where both spouses have no concerns about the surviving spouse changing the deceased spouse’s share of the Trust after their death, converting to a Simple Trust is worthy of consideration. If you would like to discuss this, please call our office and schedule an appointment with one of our attorneys to discuss your particular situation in greater detail.
Written by Mark S. Drobny on January 1, 2015, most recently revised February 1, 2017.