The New Estate Plan - It's All About That Basis

Question:  My husband and I established marital and non-marital trusts many years ago to reduce our estate tax obligation. Because the size of our joint estate is less than the current estate tax exemption, do we need to redo our documents?

Answer:  You raise a frequently asked question.  With the current Federal estate tax exemption standing at $5,430,000, many people have questioned whether they should retain a dual trust estate plan that was created when the Federal exemption was much lower.

By way of background, many high net worth individuals established trusts to take effect on the first spouse’s death allocating to one trust, commonly called a “B Trust”, an amount equal to the prevailing Federal estate tax exemption.  To the extent the assets of the first spouse to die exceed the Federal estate tax exemption, the excess would be allocated to a separate trust for the surviving spouse, often called an “A Trust”.  The B Trust was designed to fully utilize the estate tax exemption of the first spouse to die by permitting the surviving spouse to receive distributions from the trust after the death of the first spouse while having the assets in the B Trust excluded from estate taxation on the surviving spouse’s death. Assets in the A Trust would qualify for the Federal estate tax marital deduction on the death of the first spouse to die and permit the complete avoidance of tax on the death of the first spouse.  Assets that remain in the A Trust at the surviving spouse’s death along with other assets owned by the surviving spouse will be taxed to the spouse’s estate at the spouse’s death to the extent such sum exceeds the estate tax exemption.  By utilizing the dual trust format, both spouses will fully utilize their estate tax exemptions with estate taxes, if any, deferred until the death of the surviving spouse.

Increases in the Federal estate tax exemption have dramatically changed the manner in which estate plans are being prepared.  If the size of a married couple’s joint estate is less than the estate tax exemption, there is generally no need to create a B trust for the surviving spouse.  Although the continued use of the two-trust format in these circumstances will not be problematic from an estate tax perspective, it could be disadvantageous from an income tax perspective. 

With some exceptions, assets which are taxable to a decedent’s estate receive a step-up in basis on the decedent’s death.  This means that for income purposes, the basis of assets in the hands of the recipient will be increased to the fair market value of such assets on the decedent’s death.  If for example, the decedent’s estate holds stock which was purchased by the decedent for $10 per share during the decedent’s lifetime but is worth $40 per share at the decedent’s death, the basis of the stock will be increased to $40 per share in the recipient’s hands.  In this example, the appreciation of $25 per share will not be subject to income tax when the recipient sells the stock.  

In response to your question, assets in a B trust will not receive a step-up in basis at the death of the surviving spouse.  If the decedent’s assets pass outright to the surviving spouse upon the death of the first spouse to die or in a trust which is includable in the spouse’s estate for estate tax purposes, then the beneficiaries of the surviving spouse’s estate will enjoy a step-up in basis in such assets upon the death of the surviving spouse if the assets appreciate in value after the death of the first spouse to die.  The outright distribution to the surviving spouse can provide meaningful income tax benefits without incurring estate taxes due to the increased estate tax exemption.

Before modifying your estate plan documents, you should consider whether other features from the two-trust format are still desirable. Some states such as Illinois have lower estate tax exemptions than the Federal exemption and, therefore, state estate taxes should be considered.  Perhaps you or your spouse do not wish for the other to have unfettered control over the trust assets. Creditor protection might factor into your decision as well as trusts can protect assets from a trust beneficiary’s creditors. Prospective legislation may impact the arrangement as the government has recently proposed eliminating or limiting the basis step-up at death. Proposed decreases in the Federal estate tax exemption might also regenerate the need for the type of plan you have.  Barring any of these changes, modifying your estate plan documents may provide a meaningful income tax benefit.

 

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have a question you would like answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.