Old Trusts Create Tax Issues for Heirs

The big changes in estate tax law in recent years can significantly affect estate plans that were put into place under old rules.

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Not long ago, lawyers set up complex trusts for couples of even moderate wealth to protect their assets from the federal estate tax. These days, lawyers are warning that those trusts could hold a tax time bomb for heirs: burgeoning capital-gains taxes.

Because of recent increases in the estate-tax thresholds, most of those couples' estates are now free from those levies. But lawyers are prodding clients to revise these trusts so that their beneficiaries will avoid the capital-gains tax hit. "The death tax is alive and kicking, but now it's in the form of the capital-gains tax," says Matthew McClintock, vice-president for education for WealthCounsel, an association of estate lawyers. And, he says, the issue "is at least as important, if not more important, for families of modest means than for families of high wealth."

To understand today's potential problem, you have to understand the problem the trusts were created to avoid. Every taxpayer has a credit that shields a certain amount of assets from the estate tax. In addition, a marital deduction allows couples to leave an unlimited amount to a surviving spouse. If a husband owned more assets than the credit protected but passed his entire estate to his widow tax-free, he was considered to be "wasting" his credit -- because he was not protecting those assets from the estate tax that the next generation would pay after his wife died.

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Married couples for years have set up irrevocable bypass trusts, also known as credit shelter trusts, to take advantage of the credit, thereby ensuring that more assets could be passed on to the children tax-free. By assigning part of his assets to the trust after he died, the strategy permitted trust assets to bypass the estate of the widow and thus avoid the estate tax when she died.

For example, say a husband died in 2005 and his estate was worth $800,000, all of which was left to his spouse tax-free. When she died in 2008, that $800,000 had appreciated to $3 million, bringing the value of her estate to $5 million, including the wife's own $2 million in assets. Because the estate-tax credit protected $2 million in 2008, the children who inherited the assets would have owed estate tax, at a 45% rate, on

$3 million -- for a bill of $1.35 million.

But consider the outcome if the husband had left his $800,000 to a bypass trust where it appreciated to that $3 million by the time Mom died. The entire amount would have gone to the children free of estate tax. And since the exemption amount was $2 million in 2008, the kids would not have had to pay tax on Mom's estate, either.

But here's the rub. Congress in 2012 raised the estate-tax exemption to $5 million per person, indexed for inflation. The exemption in 2015 is $5.43 million with a top tax rate of 40%. And the new law also allows the surviving spouse to use any part of the exemption that was unused by the first spouse to die. That means a couple can protect as much as $10.86 million in 2015.

So what's the problem? Assets that are passed through an estate get an enormous tax break. Their tax basis is "stepped up" to the market value on the day the owner died. Any capital gains that built up during his or her lifetime become tax-free. Only appreciation after the date of death is taxable to the heir.

But assets in bypass trusts don't get the capital-gains tax break. Heirs don't enjoy that step-up in basis, and that's what estate lawyers are worrying about now.

When the estate-tax thresholds were lower, couples had a choice. They could use a trust so that part of the assets would avoid the estate tax when the second spouse died. But bypassing the estate tax also meant forfeiting the step-up in basis, so heirs would face a capital-gains tax of 15% on appreciation between the time the first spouse died and the death of the survivor. Or the couple could forgo the trust, and the kids could face an estate tax of up to 55% on the assets exceeding the exemption in the estate. The choice was easy. "We wanted to save on the estate tax, not on the capital-gains tax," says Edward "Foss" Hooper, an estate lawyer in Appleton, Wis.

The top long-term capital-gains tax rate is now 20%. These days, beneficiaries of estates such as the one above "would have an estate tax of zero but a federal capital-gains tax of 20%" on the trust assets, McClintock says.

Let's look at the earlier couple. When the father dies, his assets that go in the trust have a stepped-up basis of $800,000. But that $2.2 million in appreciation that occurs in the trust before Mom dies gets no step-up because it does not pass through her estate. If the heirs sold all the assets, they would pay up to 20% in capital-gains tax on the $2.2 million appreciation. They would pay 0% capital gains on Mom's assets outside the trust. (A trust protects an IRA's growth from estate tax, but the step-up strategy doesn't apply to IRAs.)

Pouring the Assets Into the Estate

Now, the challenge is to move assets out of the trust and into the estate, to earn the tax-saving step-up. And while bypass trusts are irrevocable, "that does not mean that trusts are unchangeable," McClintock says.

More than half the states allow surviving spouses to make changes to the trust that enable them to get the step-up. The legal mechanism is called trust "decanting" -- figuratively pouring the assets from the trust into a new one. Twenty-two states have decanting laws while another 11 states use common law, McClintock says. The laws differ by state.

Under the decanting laws, the original trust should include a provision that gives the trustee the discretion to use part of the principal to pay for the surviving spouse's expenses, says Walter Morris Jr., an estate lawyer with Wyatt, Tarrant & Combs, in Lexington, Ky. If the trust has such a provision, the trustee should be able to set up a new trust to take the assets.

The new trust would provide the surviving spouse with a "power of appointment" allowing the spouse to give some of the property to creditors of the estate. That rarely is an issue, but by giving the spouse some control over the trust assets, Hooper says, the assets in effect are pulled into the estate.Still, Morris says, this does not give the spouse complete control of the assets. The new trust, he says, could include terms that require a neutral third party, perhaps the trustee, to sign off on any of Mom's expenditures. "The children would have the assurance that she can't give property to anyone who calls and says, 'I need money,' " Morris says.

Although the assets are in a new trust, the terms provide the same protections as the old trust. For instance, if the surviving spouse remarries, the new spouse has no access to the property.

Susan B. Garland
Contributing Editor, Kiplinger's Retirement Report
Susan Garland is the former editor of Kiplinger's Retirement Report, a personal finance publication whose subscribers are retirees and those approaching retirement. Before joining Kiplinger in 2006, Garland was a freelance writer whose work appeared in the New York Times, the Washington Post, BusinessWeek, Modern Maturity (now AARP The Magazine), Fortune Small Business and other publications. For 12 years, Garland was a Washington-based correspondent for BusinessWeek, covering the White House, national politics, social policy and legal affairs. Garland is a graduate of Colgate University.