Amending Your Trust to Take Full Advantage of the Estate Tax Exemption & Eliminate Capital Gains.
For decades, the standard structure of a revocable trust for a Married Couple in California called for the establishment of an irrevocable trust upon the death of the first spouse to die, typically referred to as a “Bypass Trust, “Decedent’s Trust” “Exemption Trust” or “Family Trust.” While the Bypass Trust often benefited the surviving spouse, its main purpose was to make sure that the couple got the maximum benefit from each of their Estate Tax Exemptions. Since estate tax was charged at higher tax rate than capital gains, the primary focus in estate planning was on saving estate taxes rather than capital gains. While saving estate taxes, the downside is that the assets placed in the Bypass Trust do not receive a double step-up in basis upon the second spouse’s death. Hence when the assets in the Bypass Trust are finally sold upon the second death, those assets are subjected to higher capital gains because gains are calculated from the first death.
With the increase of the amount which a couple can pass free of estate tax to $23.16 million dollars, and other technical changes discussed below, it may be time to consider changing the structure of your Trust away from a Bypass Trust to a QTIP election. And for many clients this could mean a simple amendment to their trust which could save significant capital gains taxes with little risk.
Evolution of the Tax Law.
There is no California estate tax, and unless the California constitution is amended, there will not be one in the future. It has been an eventful several years for the Federal Estate Tax law. In 2013 the Estate Tax was raised to a $5 million exemption per person, indexed for inflation, with a 40% tax rate. In 2016, the exemption was raised again, this time to $10 million per person, adjusted for inflation. In 2020, the exemption is now $11.58 million per person, or $23.16 million per couple.
In addition to raising the exemption, the 2013 law changes introduced a new concept: the “portability” of the unused exemption of a deceased spouse. Under this law change a surviving spouse can now elect to use the unused exemption of the first spouse to die. Portability means that (provided the surviving makes a timely election within 9 months from date of death of first spouse) there could be no additional estate tax burden on the death of the surviving spouse and no capital gains tax.
These tax law changes operate to greatly reduce the risk of exposure to estate tax as only a small percentage of couples in the United States have an estate in excess of $23 million. However, every change to the tax law requires an examination of how that change may affect a particular client. One effect of a large exemption amount is it raises the question of how the interaction of the estate and capital gains tax rates could play out for most people. Because historically the estate tax was assessed at a higher rate, the primary goal of planning was to avoid estate tax by sheltering the deceased spouse’s share in a Bypass Trust. But now, because there is less chance of an estate tax liability the focus has shifted to saving on capital gains tax, which is assessed on the sale of an appreciated asset.
With Little to No Risk of Estate Tax, Does the Bypass Trust Structure Still Make Sense?
If there are other, creditor or structural reasons for the Bypass Trust, such as where the Bypass Trust does not benefit the surviving spouse, or if the couple is on a second or third marriage with kids from prior marriages, non-tax considerations might result in leaving the Bypass structure alone.
However, what of those situations where the Bypass Trust benefits the survivor? Could the “loss” of the “second step-up in basis” be significant? The surviving spouse could always take a distribution of an asset which appreciated in value after the first death, but is there a better way?
One amendment which is now becoming popular is to amend the couple’s trust so that a “qualified terminable interest property” or “QTIP” election can be made by the surviving spouse with respect to the Bypass Trust. This amendment works if the couple intends that the Bypass Trust benefit the surviving spouse, and therefore would amend the Bypass Trust to provide, among other things, that all income would be distributed to the surviving spouse.
Upon the death of the first spouse, the surviving spouse would make both the “QTIP election” and a “portability” election. The result would be that (i) the Bypass Trust would still hold and protect the assets of the deceased spouse, (ii) creditor protection would remain in place, (iii) the portability election means that the unused exemption of the first spouse to die is not wasted but (iv) most importantly, the assets in the Bypass Trust would receive that second step up in basis upon the death of the survivor.
Is the QTIP Election Right for You?
Because everyone’s situation, both tax and non-tax considerations, are different for each couple, a change to a revocable trust for a couple must be analyzed taking into consideration the current law and the clients’ current family situation. If you would like to consider amending your Trust to include the QTIP election please give us a call at (626) 793-3210 or email at LV@moravecslaw.com to discuss whether such an amendment would be appropriate in your situation.