Many people, once they have executed their revocable living trust, put it in a drawer and never revisit it. However, circumstances change over time that may warrant a review of the revocable living trust and changes made to it.
Over the last few years, the Applicable Exclusion Amount for estate taxes has risen to $5,490,000 per estate effective as of 2017. That can equate to $10,980,000 for a married couple. The vast majority of estates do not, and likely will never have, assets that exceed the Applicable Exclusion Amount and thus be subject to estate tax. Meanwhile, various income taxes have increased and new taxes have come into existence which means that, with estate planning, more people should be more concerned with income taxes rather than estate taxes.
Historically, the typical small estate plan for an estate under the Applicable Exclusion Amount would include a revocable living trust whereupon the passing of the first spouse the trust would split into a “Survivor’s Trust” and a “Bypass Trust.” The Bypass Trust is designed to hold the decedent spouse’s one-half of the community property and their separate property up to the Applicable Exclusion Amount and those assets would avoid any estate tax on the surviving spouse’s estate. Further, the Bypass Trust becomes irrevocable, and the ultimate beneficiaries of it cannot be changed. The Survivor’s Trust would hold the surviving spouse’s one-half of community property and their separate property to do with as he/she wishes.
Under the current tax system, all assets inherited from a decedent receive a step up in basis to fair market value pursuant to Internal Revenue Code Section 1014. This means all of the assets going into the Bypass Trust and Survivor’s Trust receive a step up in basis to fair market value so, if sold close in time to the death of the first spouse, there would likely be no income tax owing. However, assets distributed out of the Bypass Trust upon the surviving spouse’s death do not receive an additional step up in basis to fair market value under Section 1014 as they are not deemed to be received from the decedent second spouse to die. Accordingly, for estates where it is anticipated that even upon the second spouse to pass that the estate will remain under the Applicable Exclusion Amount, the typical Bypass Trust and Survivor’s Trust planning may not be the best plan for such estates due to the loss of the additional step up in basis to fair market value upon the passing of the second spouse.
There are various ways to plan for income tax basis step up upon the passing of the second spouse and there are many factors to take into consideration with each option. Going through all the various techniques would be a bit complicated for this article so I will briefly touch upon two basic techniques that could be employed.
The first and easiest way to obtain additional basis step up for income tax purposes on the death of the second spouse would be for the first spouse to leave all his share of the community property and his/her separate property outright to the surviving spouse. This is typically not a favored approach due to the surviving spouse not being obligated to leave the estate to the beneficiaries the decedent spouse wanted to benefit, and the lack of creditor protection. However, it is a simple and easy solution as all the assets will be deemed to be inherited from the surviving spouse and will receive an additional step up in basis to fair market value likely eliminating or greatly reducing any income taxes that will be owing on the sale of those assets.
Alternatively, the revocable trust estate plan could remain with the typical Bypass Trust and Survivor’s Trust but with an additional provision allowing a Trustee to make an election to treat the Bypass Trust as a Marital Deduction Trust if the value of the surviving spouse’s estate is likely to remain under the Applicable Exclusion Amount. This would leave the Bypass Trust (although treated as a Marital Deduction Trust) irrevocable so the beneficiaries of it could not be changed, provide some creditor protection, but also create the situation where the assets will be deemed to be included in the estate of the surviving spouse and thus deemed to be inherited from him/her and receive an additional step up in basis upon the death of the second spouse. There are some pros and cons with this planning but it achieves the main goal of an additional step up in basis for income tax purposes.
As with all tax planning there are many factors to take into consideration and what may be good for one estate may not be appropriate for another one. Things change over time and your estate plan should be reviewed periodically. If you have a non-taxable estate from an estate tax perspective, but also have assets that could need additional basis step up on the passing of the surviving spouse, you should have that trust reviewed and amended if appropriate for your situation.
– Jason W. Harrel is a Partner at Calone & Harrel Law Group, LLP who concentrates his practice in all manners of Taxation, Real Estate Transactions, Corporate, Partnership and Limited Liability Company law matters. He is a certified specialist in Taxation. Mr. Harrel may be reached at 209-952-4545 or jwh@caloneandharrel.com