Bypass trusts, or B trusts, have long been used as a strategy to help families avoid estate taxes. But with recent changes in income tax and estate tax rates, in many cases B trusts now trigger substantially higher capital gains taxes for beneficiaries or heirs without providing any estate tax savings.
An existing B trust can be a ticking time bomb, detonating after the death of the surviving spouse. Private wealth professionals should advise clients with existing B trusts to review their situation with their tax attorney or estate planner to see if corrective action is needed.
Only a few years ago, the estate tax exemption was $675,000 and the federal estate tax was as high as 55 percent. Estate planners, concerned with minimizing estate tax, turned to A-B trusts using a marital deduction formula. Most marital formulas provide that the surviving spouse’s one-half of community property interest and all of his or her separate property be allocated into the A trust. The survivor has unrestricted access to the income and principal of the A trust. All of the deceased spouse’s separate property, as well as one-half of his or her community property, is allocated to the B trust. Upon the surviving spouse’s death, the beneficiaries or heirs receive a step-up or increase in income tax basis to prevent or minimize the capital gains tax liability.
The concern for beneficiaries is that the B trust is irrevocable and, in most cases, significantly limits the surviving spouse’s access to the deceased spouse’s one-half community property interest in the trust assets. The utility of B trusts has come into question because of new estate tax rates. Today, the marital formula provisions found in these trusts can have disastrous consequences for the surviving spouse and for beneficiaries and heirs.
In 2013, the income tax and estate tax rates changed dramatically. Each person now has a $5.43 million estate tax exemption. That exemption is expected to increase to $5.45 million in 2016, which means that less than 0.2% of the U.S. population will be subject to estate tax. Very few individuals still need that estate tax exemption. However, we all pay income taxes, and those rates increased substantially in 2013 as well. In California, the highest marginal rate for capital gains is 37.1%. The capital gains tax is often one-third or more of the total gain.
B trusts can result in higher taxes during the surviving spouse’s life because trust accounting rules often require capital gains for transactions within the trust to be taxed at the trust level. The highest marginal tax rates for an individual are triggered with $413,000 in annual income and the highest marginal income for a trust is triggered at $12,300 in income. Avoiding tax at the trust level can provide substantial savings.
Upon the death of a spouse, it will likely be a shock to the surviving spouses to hear they no longer directly own half of the assets they thought they did. If the surviving spouse attempts to use the deceased spouse’s one-half of the community property, it may trigger a variety of undesirable outcomes. The B trust requires a separate tax identification number and tax return. One-half of all accounts and assets must be retitled into the B trust, which generates capital gains that may be taxed at the higher trust income tax rates. Finally, the beneficiaries may not receive a step-up in income tax basis upon the death of the surviving spouse. As a result, the beneficiaries or heirs may incur higher capital gains taxes when assets are sold after the death of the surviving spouse. Ultimately, the B trust creates additional income taxes, restrictions and headaches for the surviving spouse, all without saving any estate tax. It’s highly advisable for married couples with a trust created before 2013 to have that trust reviewed to be sure that a marital formula is not used.
What many estate planners don’t realize is that a B trust can actually be modified to prevent higher capital gains income taxes and other harsh results—however, the surviving spouse must act quickly. Despite the fact that the trust is otherwise irrevocable, it can be modified during the surviving spouse’s life. To do so, all of the beneficiaries must agree to the changes. This will likely not be a problem if the beneficiaries all face a higher income tax. (Though it could be a problem if there are children from a prior relationship or if there is a troubled family relationship.)
The best option, if time allows, is to obtain a court order modifying the trust to include the provisions needed to obtain a step-up in income tax basis to avoid the higher capital gains tax. A court appearance is the safest and best way to obtain this result. However, a court appearance requires a petitioned notice to all interested parties and consents from the other heirs. A court date in most counties is typically available 45 days after filing, which, in cases where the death of the surviving spouse is imminent, may not be sufficient time.
The use of a court order to fix or modify an otherwise irrevocable trust to create greater tax efficiently was recently approved by the IRS in two (2) private letter rulings. In private letter rulings 201737601 and 201737008, the IRS approved the use of a state court order to reform the irrevocable trust. The rulings cautioned that a lower state court order may not be respected in the event that the lower court’s ruling was contrary to the position of a higher state court.
Also, many commentators were concerned that such action might trigger a taxable gift. Without any meaningful discussion or detail, the IRS concluded that the retroactive reformation of the trust would not constitute a taxable gift.
Another backup approach to consider is “decanting” the trust, much like you would decant a bottle of wine. Decanting wine is essentially pouring wine from one bottle to another, leaving sediment and impurities behind. To decant a trust, one would “pour” the assets from one trust to another, leaving behind unwanted provisions and including new, desirable provisions. Decanting does not require the time elements of a judge and courtroom, which makes it a good option if health is an issue. However, in California, decanting does not have the same certainty of a court order. Other states, such as Nevada and Kansas, have strategies that may permit decanting or trust modification without a formal court order.
The income and estate tax worlds have been flipped upside down following the rate changes of 2013. Couples with out-of-date B trusts and their heirs and beneficiaries may be in for a financial surprise when they realize that their trust has left them with reduced assets and high capital gains income taxes.