The A/B Tax Trap (Basis Step-Up, Part II)

Welcome back! So last week we reviewed the basics of basis. This week, I’ll explain how your fancy trust, well-crafted to save you lots of estate tax back in the 1990s or 2000s, could actually end up costing your heirs money, due to changes in the law over the past few years. It all comes down to basis (which is why we went over how that works, in the last post.)

You see, a few years back, the federal Estate Tax ‘kicked in’ when someone died leaving a relatively modest estate (in 2001, $675,000; even less before that).  The amount that each person could pass at death without paying tax (what we call the “Exemption Amount”) increased a few times from 2001-2008 (when it was $2 million), but of course real estate values also increased dramatically over that time period, and many people built up substantial retirement accounts such as 401(k)s and IRAs.  Remember, too, that for estate tax purposes, we count not only your real estate and investments, but also any retirement accounts and the proceeds of life insurance payable on your death.  While there was (and still is) usually no tax on assets passed to a surviving spouse,* if all of the dying spouse’s assets (and the dying spouse’s half of joint assets) go to the surviving spouse, then when that survivor dies, his or her estate will include ALL of the couple’s assets.  This could easily cause the survivor’s estate to exceed the lower tax thresholds in effect in the 1990s and early 2000s. And the tax – with a maximum rate of 55% in 2001, declining to 45% in 2009 – was nothing to sneeze at!

So to be sure to minimize these taxes for couples who might be subject to them, estate planners came up with something called an “A/B Trust Plan,” which works like this: When the first spouse dies, instead of their entire estate passing to their surviving spouse, a portion of the estate equal to the Exemption Amount in effect in that year (for example, $675,000 if they died in 2001) is placed into a “B” (or “Bypass” or “Credit Shelter”) Trust, and the rest passes to the surviving spouse (or into an “A” or “Marital” Trust, hence the “A/B” designation). The “A” property would be included in the surviving spouse’s estate (this is necessary to avoid paying tax on it at the first spouse’s death), but the property in the “B” trust, though available for the surviving spouse to use, is NOT included in his or her estate at death (this is accomplished by the design of the “B” trust). This helped to keep the survivor’s estate below the Exemption Amount (or if that’s not possible, as low as possible), by having some of the assets of the first dying spouse “bypass” the estate of the second spouse to die.

Now, however, with the “Exemption Amount” much higher – for 2014, it’s $5.34 million per person – and the ability to increase it further, even DOUBLE it, for a surviving spouse using something called “portability,” the “bypass” procedure is almost always unnecessary, since there will be no estate tax on the second spouse’s death even without it.  But, you may ask yourself, if the assets are simply taken out of the surviving spouse’s estate for tax purposes, then what’s the harm? Why do we have to mess with it?

Well, consider this: anything that is NOT in the surviving spouse’s estate when he or she dies (which, for most couples today with an A/B Trust Plan, will be one-half of their joint assets – perhaps more if the spouse who owned the bulk of the property died first), does NOT get a ‘step-up’ in tax basis at the surviving spouse’s death!  So if the couple had a home, or other assets, that have appreciated in value, and are likely to continue to appreciate in value after the first death, and half of those assets are owned by each spouse, then on the first spouse’s death, his or her half of the assets will go into the “B” Trust. If the surviving spouse then lives for 10 or 20 more years, when he or she eventually dies, the children or other beneficiaries will get a ‘step-up’ in basis on only HALF of the couple’s assets – the half that was in the “B” trust will get no step up. Since it is often more likely that the family home will be sold by the children (or other recipients) after BOTH spouses have died – and also that the children will not have lived in the home for a sufficient time to be able to exclude gain using the ‘primary residence’ exclusion – this could result in a large capital gains tax bill for the children, when the home is sold after both parents have died.

Bottom line: in many cases, the sole reason for using an “A/B” trust plan, back in the 1990s and early 2000s, was to avoid estate taxes at the second spouse’s death. Now, due to changes in the tax laws and increases in the exemption amount, the “A/B” split is often not needed to avoid estate taxes, and it can actually cause a substantial increase in income taxes for the beneficiaries after the second spouse’s death. (It can also create unnecessary administrative complexity for the surviving spouse; however, an A/B Plan can nevertheless be warranted if the estate is fairly large, and/or for certain non-tax reasons.) So if you have an old trust plan (whether a single, joint trust, or two separate, individual trusts), you should have it reviewed TODAY to see if a change could save your beneficiaries a LOT of money!

* If the survivor is a U.S. citizen; different rules apply to non-citizen spouses.

Published in: on November 9, 2014 at 1:10 am  Leave a Comment  

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