- Laura Rose Nelson
THE MARITAL EXEMPTION / BYPASS TRUST - ONCE A SOUND TAX SAVINGS STRATEGY, NOW AN UNNECESSARY BURDEN
When is the last time you brought your revocable living trust to a lawyer for review? Many people complete their estate planning, toss their living trust in a safe or drawer somewhere in the house, and forget about it for the next twenty years or until it is needed. My usual advice is that families consider a thorough review of their estate plan every two years, or when they experience major life changes, including changes in wishes, changes in the family, and changes in law. This article focuses on changes in law that may affect your estate planning if you signed a revocable living trust prior to 2011.
THE MARITAL EXEMPTION / BYPASS TRUST
Many couples who completed their estate planning prior to 2011 have an “A/B” trust, commonly known as a marital exemption trust or a bypass trust, which provides tax planning to help avoid or reduce the federal estate tax. Prior to 2011, even modest estates could be subject to a hefty federal estate tax. In order to avoid paying the tax, these marital exemption trusts require a division of assets upon the death of the first spouse to die. The surviving spouse is required to divide the couple’s assets and allocate a portion of the assets to the surviving spouse through a revocable survivor’s trust and allocate the remaining assets (usually the assets of the deceased spouse, including one-half of the couple’s community property) to an irrevocable trust. This irrevocable trust is administered separately, which usually requires the surviving spouse to separately account for assets and file annual tax returns. The trust is irrevocable, meaning it cannot be amended by the surviving spouse. Although the surviving spouse receives income produced by the assets of the irrevocable trust, he or she can only reach the principal assets under certain conditions.
CHANGES TO FEDERAL TAX LAWS
This type of trust planning was considered sound tax planning before the federal government enacted several laws that significantly changed the federal estate tax. The first change came about in 2011 when Congress enacted portability of the federal estate tax (which was then made permanent in 2013). With portability, a married person can preserve their deceased spouse’s unused federal estate tax exemption simply by filing a timely federal estate tax return (Form 706). This change effectively doubled the amount of wealth a married couple can pass to their heirs without paying a federal estate tax, and without any trust planning whatsoever. Then, in late 2017, President Trump signed into law new tax reform legislation that doubled the federal estate tax exemption. Now, with a timely filed estate tax return, a married couple can pass $23.16 million (increased annually for inflation) to their heirs without being subject to a federal estate tax. A note of caution, however – the current exemption amounts are set through 2025, but scale back to pre-tax reform levels if new legislation is not enacted. However, even with the pre-tax reform exemption amounts, a married couple can effectively pass over $11 million to their heirs without paying a federal estate tax. This is sufficient for most families, and no trust tax planning is necessary.
WHY YOU SHOULD BYPASS THE BYPASS TRUST
The changes in federal law have made marital exemption trusts obsolete for tax planning purposes. However, many people still have a pre-2011 trust that provides for the irrevocable exemption trust administration upon the death of the first spouse to die. While it provides no tax benefits, the martial exemption trust actually increases costs and burden on the surviving spouse. The survivor must administer the trust as a separate share and file income returns annually. In addition, funding assets into the irrevocable trust may actually cause beneficiaries tax losses as the assets will not receive a step-up in basis on the survivor’s death (meaning beneficiaries will pay taxes on appreciation that occurs after the first spouse’s death). In addition, for many families, their home is their main trust assets. Depending on the couple's assets upon the first death, the exemption trust may require the surviving spouse to transfer a portion of the home into an irrevocable trust and administer it as a separate asset. This is a substantial burden to the survivor with no real benefit in most cases. (In certain specific cases, a martial exemption trust may have benefits other than tax savings, such as protection for the deceased spouse's beneficiaries. This can be determined on a case-by-case basis through review of the trust and unique family situation.) Since a marital exemption trust is irrevocable upon the first spouse’s death, the survivor’s only options are to administer the irrevocable trust as written or petition a court for modification of the trust, which can be a costly endeavor.
Though the changes to the federal estate tax laws are not new, I am finding more and more families with outdated marital exemption trust planning. Most often, these families end up in my office only after one of the spouses has died and the survivor is stuck administering the irrevocable exemption trust. Oftentimes, the survivor is shocked that the once revocable living trust requires such an administration. In order to avoid this, my recommendation is for all couples with a pre-2011 trust, or with marital exemption or bypass trust planning to have their trust reviewed by an estate planning lawyer to consider an amendment that will remove the unnecessary federal estate tax planning. It is crucial to do so before the first death to eliminate the burden on the surviving spouse.
Laura practices almost exclusively in the field of estate planning, trust and probate law. She is a board-certified specialist in Estate Planning, Trust and Probate Law and licensed real estate broker. She can be reached by email at firstname.lastname@example.org or by telephone at (530) 295-6400.