A Trap for the Unwary

A tax trap, that is. If you (1) are married, (2) have a small or moderate-sized estate (under $10 million), and (3) created a trust-based estate plan at any time in the past several decades, chances are that plan could end up costing your children or other beneficiaries a LOT in unnecessary taxes after you die.  Now, this probably does not apply to you if you live in one of a handful of states that imposes a state estate tax with a low exemption amount (CT, DC, ME, MD, MA, MN, NJ, NY, OR, RI, and TN all have exemption amounts for 2013 that are $2 million or less), in which case your planning has probably been designed to minimize those taxes, as well as the Federal estate taxes, and that may save you more in the long run.  But if you live in one of the many states that has no state estate tax (a list of states with an estate tax can be found here), or has an exemption greater than the value of your estate, keep reading to find out why your plan may be in need of a critical update.

This “trap” results from the “A/B” (or “A/B/C”) trust split that used to be necessary to reduce or eliminate Federal estate taxes, which are imposed if an individual dies leaving property above a certain value (the ‘exemption amount’) to anyone but his or her spouse. Because the applicable exemption amount used to be much lower than its current $5.25 million, and there was no “portability” of exemptions between spouses, it was necessary to design trusts so that each spouse could use his or her full exemption amount, by passing some (or all) of his or her property into a special trust (called an “Exemption Trust,” “Bypass Trust,” “Credit Shelter Trust,” or “B Trust” – we’ll call it an Exemption Trust here) that would not be included in the taxable estate of the second spouse to die. This saved a lot of estate taxes, when the exemption was lower and all amounts above the exemption amount were taxed at exorbitant rates, up to 55% in some years.

Now, with the higher exemption and portability between spouses (this means that if the first spouse to die does not use all of his or her exemption, the other spouse can claim it by filing a tax form, and possibly pass over $10 million to children or other beneficiaries with no estate tax at all), many couples don’t need to have an Exemption Trust created when the first spouse dies, to avoid estate taxes. (There may still be other, non-tax reasons to do this, so of course you should check with your estate planning attorney to see if changes are right for you.) But what’s the harm, you may say? The Exemption Trust doesn’t hurt anything, even if it’s not necessary, right? WRONG!!  If property flows into an Exemption Trust when the first spouse dies, and then grows in value before the second spouse passes, the tax basis of that property in the hands of the children or other beneficiaries will be the value when the FIRST spouse died, and all that growth that happened between the two deaths will be subject to capital gains tax when the property is sold.  So if the kids then sell the property, they will have to pay capital gains tax (currently 15% or 20%, plus any tax imposed by the state) on the difference between the selling price and the value when the first spouse died. This could be substantial! 

BUT, if the property wasn’t put into the (possibly unnecessary) Exemption Trust, it could be left for the benefit of the surviving spouse in other ways, that would result in the tax basis being increased when that second spouse died, to the value of the property at that time. This would eliminate any capital gains on the appreciation between the first death and the second. (This only works if the surviving spouse does not sell the property, but holds onto it until he or she passes.)

This is important because many times a home is not sold until after both spouses have died, but when that does occur, the children or other beneficiaries often want to sell the parents’ home or other real estate. If property worth $500,000 goes into an (unnecessary) Exemption Trust at the first spouse’s death, even if that property only appreciates at a rate of 2% per year, then 10 years later when the second parent dies, the children could end up paying over $20,000 in (unnecessary) capital gains taxes! This could be avoided by having the property NOT go into an Exemption Trust on the first spouse’s death, but many, many estate plans that were drafted over the past 20 years do not allow that. Many plans, due to the size of the estates and the current exemption, channel half of the couple’s assets into the Exemption Trust, whether it is truly necessary to avoid estate tax or not.

So please, if you have a estate planning documents that include “A/B Trust” planning, a “Marital” and “Bypass” trust, a “Credit Shelter” trust, or if you’re just not sure, consider asking an estate planning attorney to review your documents and discuss your situation, to see if your children or other heirs might be caught in this “Tax Trap” after you are gone. Only an experienced and careful planner can help you to decide whether this type of planning – which was, for many years, touted as the best thing for almost everyone – is truly appropriate for you.