New Tax Law Encourages Reviewing Your Trust for Needed Changes
By James LanhamJanuary 10, 2018
When President Trump signed the new "Tax Cuts and Jobs Act" tax plan into law on December 22, 2017, the asset exemption from federal estate taxes doubled to more than $11 million per person and over $22 million per couple. The state of Ohio completely eliminated its estate tax starting in 2013. If you call to inquire about how this change may affect your estate plan, the conversation might sound like this (if you can stay awake long enough):
Client Our estate is still a bit south of $22 million, so is it safe to assume that we don’t need to change our estate plan?
Jim [SUMMARY FOR THOSE WHO DON’T HAVE TIME OR THE DESIRE TO READ A WHOLE BLOG!] Strongly consider having your trust reviewed by one of our estate planning attorneys. Older trusts drafted for couples (especially those written before 2013 for Ohio residents) were designed to reduce estate/death taxes but usually created an income tax problem for the children, but that was the lesser of two tax evils (40% estate tax vs typical 15% capital gains for income tax). Also, even if a trust is no longer necessary for tax planning, we will design your trusts to anticipate negative tax changes, to keep your assets private, to give your trustees immediate control of assets at death, to avoid the probate process for assets in the trust, and perhaps most importantly, to completely shelter the assets from your children’s creditors or a bad marriage for life.
C Well, I’d rather not pay for a trust review without understanding why a change is likely in order.
J Well, if you hear how complicated the explanation is, you might pay me to shut up!
C That’s frightening, but since you’re not billing me for this call, I’ll take my chances.
J I’m looking at your A-B trust as we speak. Couples with A-B trusts should strongly consider changing their trusts which were designed to beat estate taxes at the expense of potential income taxes. Some simple changes now allow you to beat the estate tax and income taxes.
C What’s an A-B trust and why do we have them?
J Prior to 2013, couples with over $600,000 in combined assets would pay Ohio estate taxes and often would pay federal estate taxes if all of the assets in the first spouse’s estate passed directly to the surviving spouse through a simple will or joint ownership. This was because the 2nd spouse only enjoyed one estate tax exemption of $338,000 dollars. Anything over $338,000 suffered from estate taxes at that second spouse’s death. The first spouse’s exemption was lost by not using a trust.
C How would the A-B trust allow both spouses to use both of their estate tax exemptions?
J That same couple could instead have used trusts which placed $338,000 of the first spouse’s estate assets into a “B” trust which was offset by the $338,000 estate tax exemption resulting in no estate tax on the B trust. The balance of that spouse’s assets were held in the “A” trust which was not estate taxed since the A trust was treated as passing to the surviving spouse estate tax free, but the A trust share would subsequently be estate taxed in the second estate. The surviving spouse has to include the first spouse’s A trust assets in the second estate tax calculation, but that surviving spouse could use his/her own $338,000 exemption as well, thus doubling the estate tax shelter for the couple. Federal estate taxes worked the same way.
C Wow, that is complicated as promised! So the A-B trust saved significant estate taxes, but how did that harm income taxes?
J In a traditional A-B trust, assets go first into the tax sheltering B trust up to the amount of the estate tax exemption without paying estate taxes. The assets in the tax sheltered B trust could then double or triple in value by the second spouse’s death and there would be no additional estate tax on those assets because the B trust is not taxed in the second estate. Remember that assets exceeding the exemption amount go into the A trust and are not taxed because they are treated as passing to the surviving spouse but then get taxed in the second spouse’s estate.
C I’m catching on, but you haven’t told me how the A-B trust is bad for income tax planning. I’m feeling drowsy.
J Let’s look at an example. Suppose husband died in 2011 with $2 million and an estate tax exemption of $1 million. Husband’s B trust might have been funded with $1 million in high growth stocks while the A trust was funded with a house and other assets totaling $1 million. The A trust wasn’t estate taxed since it passed to the wife estate tax free (to be taxed in her estate), and the B trust wasn’t estate taxed since that $ 1 million was offset by husband’s $1 million exemption. Wife dies 6 years later enjoying a $5.49 million estate tax exemption owning $2 million of her own assets, $2 million in husband’s A trust, and husband’s B trust has grown to $3 million. The couple beat the estate taxes because the husband’s B trust $3 million is not estate taxed in wife’s estate and the $2 million of her assets combined with husband’s A trust $2 million of assets are offset by wife’s $5.49 million exemption.
C That’s peachy, but I still haven’t heard why the A-B trust caused income tax problems! If I ask you for the time, you’ll probably build me a watch!
J The problem is that the basis in the B trust is frozen at the first spouse’s death. If the children want to sell the B trust stocks in our example, they get the pleasure of paying $400,000 in capital gains tax on the $2 million growth since the B trust stocks have a basis of $1 million at husband’s death and are now worth $3 million at wife’s death. It bears repeating that wife, however, pays no estate taxes on the B trust’s $3 million since all of its growth is exempt in the second estate, and the other $4 million - including wife’s $2 million and husband’s A trust $2 million - is exempt from estate tax using wife’s 2017 exemption of $5.49 million. The kids get the entire inheritance estate tax free but not free of income taxes should they sell the B trust stocks.
C How can you fix our A-B trusts so our kids won’t have to pay estate taxes or income taxes resulting from capital gains on the first estate’s asset growth?
J There are several different fixes we use depending upon your asset level. Essentially, we simply change your trust so that all assets in the first estate are treated as A trust assets; they are not taxed in the first estate because they’re treated as though passing to the second spouse to be taxed in the second estate. Thus, all of the couple’s assets are “estate taxed” in the second estate to get a brand new basis at the second death. In our example, the whole $2 million in the first estate which grew to $5 million by the second death in husband’s A-B trust would have a new $5 million basis, so when the kids sell the stock at the second death there are no capital gains, thus eliminating the income tax problem. Since the second spouse now enjoys over $11 million in estate tax exemption, there is also no estate tax on second spouse’s $7 million total estate.
C Couldn’t I just eliminate my trust completely and set everything up to automatically pass to my spouse and get the same result?
J You could, but the second spouse’s estate could end up in the probate process which often requires more time to settle than a trust, more expense to settle than a trust, details the couple’s assets in a public record, subjects the entire estate to the decedent’s creditors and to creditors of the children, including disabled children who can lose government benefits through probate inheritance. Your trust keeps your assets private, gives your trustee immediate control of assets at death, avoids the probate process for assets in the trust, and perhaps most importantly, can completely shelter the assets from your children’s creditors or a bad marriage for life.
C Can I use my lifetime exemption and give $11 million to my children estate tax free?
J Maybe. The larger $11+ million exemption ends on December 31, 2025, then the exemption reverts to the $5 million number adjusted annually for inflation. The new law requires regulations intended to allow the bigger gifts now without being penalized for dying after 2025 when the exemption numbers shrink. If such regulations are created and you have $11 million you don’t need, gifting it before January 1, 2026 could be a good plan. Business owners may be able to easier shift the value of their companies to the next generation with the larger gift caps.
The other problem with gifting is that the recipient then stands in your shoes for basis, but if children instead inherit the assets, the basis is adjusted at death. If you give children $11 million in stock that you bought for $2 million, their sale of that stock would trigger $9 million in taxable capital gains. If the children inherit that same $11 million of low basis stock and sell right away, they pay zero dollars in capital gains due to the new $11 million of basis stepped up at death.
C My head is spinning after this A-B trust discussion. I’ll bet your dinner conversations are real snoozers! Tell me what to do so my sixth grader could understand.
- Pre-2013 trusts. If your trust was written before 2013, strongly consider retaining our estate planning attorneys to review your estate plan to recommend any necessary changes.
- Post-2013 trusts under $5 million. Most trusts written after 2013 by our firm attorneys already use the “fix” described above unless the couple’s assets exceed the $5 million range. A quick review by our estate planning attorneys can confirm this for you.
- Post-2013 trusts over $5 million. If your trust was written in 2013 or after and your family’s assets are in excess of $5 million, strongly consider hiring us to review your estate plan to recommend any necessary changes.
- Assets over $11 million. If your family’s assets exceed $11 million, more sophisticated planning is likely in order and the A-B trust may still be the best plan. Since the current large estate tax exemption expires in 2026, there may be gifting opportunities for wealthy families, but tax planning for an estate will have to be tailored to each family’s situation.
- Changes in your Family. You should still consider a trust/estate planning review whenever there is a change in your family (how can we help new grandchildren pay for college, what do we do since our child died, how can we help our disabled granddaughter without causing a loss of benefits, etc.) and, without family changes, every 3 to 5 years just to catch up on changes in the law.
Feel free to contact Jim Lanham with questions at 330.264.4444 or firstname.lastname@example.org.