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11.02.15   |   Insights

Having Your Cake and Eating It, Too; Lower Estate Taxes May Merit Repair of Your Trust

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Ohio State Bar Association Certified Specialist, Estate Planning, Trust and Probate Law

Mr. Weaver married his high school sweetheart Edith, and shortly thereafter, ostensibly on a business trip to Vegas, Mr. Weaver also married a second girlfriend, Kate. In our small town, the word got out quickly that he was married to both Edith and Kate. He was arrested, tried and found guilty of polygamy. He asked the judge for leniency due to ignorance of the law to which our judge responded, “I’m sorry Mr. Weaver, but everyone knows, you can’t have your Kate and Edith, too!”

A significant portion of our clients’ revocable trusts were designed to save estate taxes, especially for married couples. There is good news on that front. Most families no longer have an estate tax problem due to Ohio eliminating its estate tax and due to the $10.86 million asset exemption from federal estate taxes that couples now enjoy. The bad news is that a potential side effect of this good tax news is that many clients’ trusts should be reviewed and revised to avoid an embedded income tax problem in older trust plans. With older trusts, you can’t have your cake and eat it too.

When Ohio estate taxes were high and the federal estate tax exemption was low, trusts were designed to “freeze” the value of the first dying spouse’s estate so those assets would not be subject to estate taxes in the second estate. A couple which signed their trusts in 1999 with $1 million in family assets for example, had two federal exemptions to use of $650,000 per spouse. If each spouse had half of the assets and used a simple will in lieu of a trust to pass all assets to the surviving spouse, there would have been no estate tax at the first death (assets passing directly to a spouse are not taxed), but the first exemption would be lost. As a result, the second spouse dying would only have a $650,000 exemption against $1 million in assets resulting in federal estate taxes exceeding $140,000. Enter the trust. At the first spouse’s death, husband’s $500,000 in his trust was “taxed” since it was not directly passing to his wife, but his $650,000 asset exemption eliminated the estate tax. At his wife’s later death, their children also paid no death taxes on her $500,000 trust thanks to her $650,000 exemption. The only bad news was that the $500,000 in husband’s estate had a frozen basis of $500,000. If those assets grew to $1 million by the time his wife died, the children would have to pay capital gains tax on half of every dollar for any of husband’s assets being sold. The frozen basis creates a profit which is taxed at the time the children make the profit. The estate tax was fully eliminated by the trusts, but there were income tax detriments baked into that planning.

Wind forward to the present. That same couple has no estate tax problems since their combined asset exemption of $10.86 million eliminates their death tax consequences for a $1 million estate. Their trust written in 1999, however, will still freeze the basis at the death of the first spouse for that spouse’s assets; when both spouses are deceased, the children will face income taxes on any asset growth after that first death should the children desire to liquidate assets from the first spouse’s trust. If instead the trusts were amended to allow husband’s assets to receive another step up in basis at his wife’s later death, the children could liquidate any of dad’s assets after mom’s death and pay virtually no income taxes on the sale.

The 1999 trust in our example is easily repaired with an amendment to the trust which, for estate tax purposes, passes all of the first dying spouse’s assets to the surviving spouse so all of the couple’s assets will be “taxed” in the survivor’s estate. This allows all of the couple’s assets to receive a new basis at the second spouse’s death. Since the estate tax exemption is so large, this couple will face no estate taxes. The amendment also would allow for the surviving spouse to freeze some of the deceased spouse’s assets for estate tax purposes in the event that the exemption is reduced again by Congress or in the event that Ohio reinstitutes the estate tax in the future. If your trust was drafted before 2013, it would be prudent to review it with your attorney to ensure that you can have your cake and eat it, too!

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