In the past, estate planning was mostly about reducing the impact of the federal estate tax. The tax was so onerous, and potentially affected so many people, that the goal was to avoid it like the plague.
One way to reduce estate taxes was to put assets into an irrevocable trust. The tax savings could be accomplished in a number of ways, but the key was that, when the person who created the trust died, the trust assets would go on to benefit his or her heirs, and would not be subject to the estate tax.
This was very smart planning at the time. Over the last few years, however, the situation has dramatically changed.
For one thing, the federal estate tax is now much less of a burden. This year, the tax doesn’t even kick in at all unless a person who dies has an estate of more than $5.43 million. So unless a single person is worth at least that much (or a married couple is worth at least $10.86 million), it’s simply not an issue.
At the same time, though, capital gains taxes have increased significantly. The federal rates have gone way up, many states have hiked their own rates, and a new 3.8% Medicare surtax on capital gains has been imposed on many taxpayers.
The new, higher capital gains rates can be a big problem for people who in the past have used irrevocable trusts in their estate planning. Here’s why: Suppose Sally dies, and in her will she leaves stocks, real estate, or other assets that have appreciated in value to Jim. For capital gains purposes, Jim’s “basis” in these assets will be their value at the date of Sally’s death – and not their value when Sally first bought them. Jim’s basis will be “stepped up” to the date-of-death value of the assets. So if Jim sells them soon afterward, he’ll owe little if any capital gains tax.
But if the assets don’t go to Jim in Sally’s will, and instead he receives them via an irrevocable trust, in many cases Jim’s basis will not be “stepped up.” He’ll have to pay tax on all the appreciation in the assets’ value since the time when Sally first bought them.
This means that many irrevocable trusts, which were set up years ago as a tax benefit, have suddenly become a tax burden. In many cases, the trusts are no longer necessary to avoid the federal estate tax, and the family might have to pay less in taxes overall if it were possible to undo the arrangement and have the trust assets be treated as part of the donor’s estate.
Undoing a trust isn’t always feasible, but if there’s an irrevocable trust in your family, it’s worth talking to an attorney to see if something can be done.
For instance, if the irrevocable trust is a grantor trust – one that is taxable to the donor – then in some situations, Sally might be able to “swap” assets in the trust.
Suppose some of the trust assets have greatly appreciated in value and have a low basis. If Sally owns other assets that haven’t appreciated in value and have a high basis, she could “take back” the low-basis assets from the trust, and pay for them with the high-basis assets. As long as the assets are of equal value, there might not be any problem with this – but the resulting capital gains taxes would be greatly reduced.
In the past, many couples’ wills created a trust at the death of the first spouse. This trust provides income to the surviving spouse during his or her life, with the assets going to the children when the second spouse dies. In such a situation, it might be possible to selectively distribute low-basis trust assets to the surviving spouse, to move as many of them as possible into his or her estate and out of the trust.
There’s even a technique in some cases whereby Sally could “appoint” the trust assets to go instead to an elderly family member – let’s call him Phil – with a short life expectancy. Phil would then appoint the assets to go to Jim when he dies. The trust assets would get a step-up in basis at the time of Phil’s death. As long as the assets aren’t large enough to cause Phil’s estate to owe any estate tax, everyone benefits. (This technique is tricky, though, and only works in limited circumstances.)
Finally, if the trust’s terms don’t allow any of these alternatives, it might be possible to move the assets into a new trust with different rules. This is sometimes called “decanting” a trust, because the assets are being poured from an old container into a new one. Some 22 states currently allow decanting of irrevocable trusts in at least some circumstances.
In any event, it’s worth taking a second look at any irrevocable trusts, so that yesterday’s tax savings don’t become tomorrow’s tax nightmare.