Q. My wife and I had our Living Trust prepared back in the year 2008. I hear there have been changes in tax law since then which might affect us. Is it time to have our trust reviewed?
A. You refer to the Tax Cuts and Jobs Act,” (“TCJA”) signed by former President Trump on 12/22/2017, which has temporarily enlarged the current estate tax exemption to over $12 million per person for those dying between 2018 and 2025. It also permits a married couple to effectively double their exemption even without special estate tax planning, provided they so elect by filing a timely Estate Tax Return Form 706 after the death of the first spouse. Unless Congress votes to extend that TCJA before 2026, when it is otherwise scheduled to “sunset”, the estate tax for persons dying thereafter will likely return to the prior exemption, which was approximately $5,250,000 (plus increases for inflation) under the American Taxpayer Relief Act signed by former President Obama.
By comparison, when you created your own trust, the estate tax exemption was much smaller and special tax planning was required to minimize estate taxes. At that time, your attorney probably recommended a form of trust which was tailored to the lower estate tax exemption, namely a Living Trust with a Bypass Sub-Trust built into it. This Bypass Sub-Trust is also known as a “B Trust,” an Exemption Trust, a Family Trust, and a Credit Shelter Trust.
Bypass Trusts typically require that, on the death of the first spouse, a share of the couple’s assets be transferred into an irrevocable sub-trust called the “Bypass Trust”, rather than to the survivor directly. This is to preserve the first spouse’s estate tax exemption for later use at the survivor’s death. Without the Bypass, the first spouse’s exemption would be lost and all trust assets at the survivor’s death would be sheltered by only the survivor’s one exemption and the excess (if any) was exposed to an estate tax at a rate as high as 55%. Understandably, couples went to great lengths to avoid that tax.
The typical Bypass Trust was not, however, without its problems: (1) the survivor typically lost the right to make any changes in the Bypass portion even if family circumstances have changed, (2) the survivor’s access to the assets in the Bypass portion was usually restricted, (3) the Bypass trust could interfere with applying for a Medi-Cal long-term care subsidy, (4) the assets in the Bypass portion usually do not qualify for a 2nd date-of-death “step-up” in tax basis upon the later death of the surviving spouse, with increased exposure to a later capital gains tax when and if the ultimate recipients (usually the children) opt to sell the appreciating asset(s), and (5) the Bypass Trust usually required separate accounting and income tax returns during the life time of the survivor. Surviving spouses usually found the restrictions burdensome.
Two important new developments arrived with the new law: (a) as of 2018, the amount of the estate tax exemption has now increased to over $12 Million per person, and is annually adjusted for inflation, and (b) the unused portion of the first spouse’s full exemption can now be preserved for use by the second spouse even without the use of the restrictive Bypass Trust, effectively doubling the exemption for most couples.
In view of these new developments, couples with Bypass Trusts created for estate tax purposes under old tax law should have their trusts reviewed and, where appropriate, consider eliminating the mandatory funding feature at the first spouse’s death. Instead, they might now consider plans which give the survivor the option of doing postmortem planning after the first death, e.g. by funding a portion of trust assets into an optional Disclaimer Trust. The Disclaimer Trust would then operate as a tax-saving Bypass Trust if that later appeared necessary due to the increase in value of the couple’s estate.
An exception to the above recommendation: The use of the mandatory Bypass Trust can still be useful for non-tax purposes, e.g. in situations involving second marriages. Here, each spouse usually wishes to provide financial security for the survivor, but also wishes to preserve a portion of assets for his/her own children. Under these circumstances, a Bypass Trust can still help these couples achieve their estate planning goals.