Yesterday, I met with a Client whose parents had a trust prepared by another firm. Her dad died years ago and his trust included a formula clause that required funding a "B" or Bypass Trust on his death. My Client's mom just died and she is learning that the "B" Trust will result in additional capital gains income taxes of about $60,000 when the kids sell the stock held in the "B" Trust. We recently met another Client where the additional taxes were over $200,000 from the sale of the appreciated stock in the "B" Trust. Federal and California capital gains income tax can be as much as 1/3 or more of the amount received. These taxes on a "B" Trust may often be avoided if timely action is taken.
The income and estate tax worlds are now upside down. In 2013, the income tax and estate tax rates and rules were dramatically changed. Each person now has a $5.43 million exemption for estate tax purposes. This exemption is indexed to increase with inflation. In other words, a person can leave $5.43 million in assets to family or other heirs without paying any estate tax. The estate tax rate is now 40%. Fewer than 5% of all estates will be subject to estate tax under these rules. However, we all pay income tax. The combined federal and California income rates increased in 2013. The highest combined marginal income tax rates for California is 57%.
However, not too terribly long ago, the estate tax exemption was only $675,000. The estate tax rate has been 52% and even 55%. Estate planners were very concerned about minimizing estate tax. One of the tools most commonly used by estate planners is an "A-B" Trust or "ABC" Trust which utilizes a marital deduction formula. These formula provisions can have disastrous consequences for the surviving spouse and for the children or heirs.
Most marital formulas provide that the surviving spouse's one-half (1/2) community property interest and all of the surviving spouses separate property is allocated to the "A" Trust. The surviving spouse has unrestricted access to the income and principal of the "A" Trust. Upon the surviving spouse's death, the children or heirs receive a step-up or increase in income tax basis to prevent or minimize the capital gains tax liability.
The problem is that the deceased spouse's one-half (1/2) of the community property and all of the deceased spouse's separate property is allocated to the "B" Trust. The "B" Trust is irrevocable and most often significantly limits the surviving spouse's access to the deceased spouse's one-half (1/2) interest in the trust assets.
Upon the death of the first spouse, this causes a very difficult conversation with the surviving spouse when I need to explain that he or she no longer owns half of the assets that they think they own. The conversation gets worse as I explain that a separate tax identification number is needed for the "B" Trust and a separate tax return is also required for the "B" Trust. One-half (1/2) of all accounts and assets must be retitled into the "B" Trust which generates capital gains that may be taxed at the higher trust income tax rates. Finally, the children may not receive a step-up in income tax basis upon the death of the surviving spouse. As a result, the children or heirs may incur higher capital gains taxes when assets are sold after the death of the surviving spouse. All of these additional income taxes, complexity and restrictions upon the surviving spouse's use of the deceased spouse's one-half (1/2) of the community property occurs even though no estate tax is saved! A married couple with a trust created prior to 2013 should have that trust reviewed to be sure that a marital formula is not utilized.
An existing "B" or Bypass Trust can be modified to prevent this harsh result and the higher capital gains income taxes. However, you must act before the surviving spouse dies.
The Bypass Trust can be modified during the surviving spouse's life despite the fact that the Trust is otherwise irrevocable. To do so, all of the beneficiaries must agree to the changes. This may not be a problem if the beneficiaries all face a higher income tax.
The best alternative if you have sufficient time is to obtain a Court Order modifying the Trust to include the provisions needed to obtain a step-up in income basis to avoid the higher capital gains tax. A Court appearance is the safest and best way to obtain this result.
However, a Court appearance requires a petitioned notice to all interested persons and consents from the other heirs. A courtroom and hearing date in Sacramento is typically available 45 days after filing. Sometimes death may be imminent and that much time may not be available.
Another back up approach to consider may be to "decant" the Trust. Most of us think of decanting as being applicable to wine. Decanting wine is essentially pouring wine from one bottle to another and leaving sediment and impurities behind. (For wine, we also want wine to breathe, but that's another topic). To decant a Trust, we are pouring the assets from one Trust to another to leave behind unwanted provisions and include new provisions that may be desired. To be clear, decanting in California does not have the certainty of a Court Order. Decanting does not require the time elements of a judge and courtroom and may be a good back up course of action if health is an issue.
If you have an existing "B" Trust, call our office to see if that can be fixed to avoid higher capital gains income taxes. If your trust was created prior to 2013, or if you have an A/B marital formula in your living trust, call the Goralka Law Firm to see if this needs to be corrected.