How to Fix a Trust Dilemma to Prevent a Tax Bomb

A white puzzle piece sits outside the rest of a puzzle against a yellow background.

Many clients and even other professionals are unaware that an irrevocable bypass trust, or funded B trusts, can be corrected to prevent higher ordinary income tax during the surviving spouse’s lifetime and higher capital gains tax upon the surviving spouse’s death. To understand the issue, a little history and background are needed.

First, every U.S. citizen is entitled to a lifetime credit against estate tax. This works like a very large standard deduction on an income tax return. Net estate values below this amount are not subject to estate tax.

The estate tax exemption is presently at $13.61 million, or a combined $27.22 million for a married couple. A net estate value in excess of that exemption is subject to a 40% tax. Not too terribly long ago (in estate planning terms), this exemption was only $500,000. Net estates with value in excess of that amount were subject to a 60% tax. Almost everyone was worried about estate tax then. Please see below for a comparison of a few years.

Second, if you leave all of your estate to your spouse and your spouse leaves the remaining estate to your children or other loved ones, then you lose one of those lifetime credits. This is because transfers to the surviving spouse qualify for an unlimited marital deduction, so no credit is used on the death of the first spouse. When the surviving spouse dies, then only the surviving spouse’s exemption is available.

A trust was created to address this

To address this problem, the AB, or bypass, trust concept was created. Often, a formula is embedded into the trust that compels the allocation of all or a portion of the deceased spouse’s assets to the bypass trust. The bypass trust limited the surviving spouse’s access to the trust principal. For example, the bypass trust principal can be used for the surviving spouse’s health, education, maintenance and support. The bypass trust assets are outside of the surviving spouse’s estate for estate tax purposes.

As a result, there is no step-up or increase in income tax basis upon the surviving spouse’s death, triggering much higher capital gains when assets are sold. The surviving spouse’s share would be allocated to an A trust, or survivor’s trust. The surviving spouse has full access to these assets and has a step-up income tax basis. This means assets can be sold after the surviving spouse’s death with no or much less capital gains. Note also that the surviving spouse can change trust beneficiaries. The surviving spouse is limited in his or her access to the bypass trust and cannot change bypass trust beneficiaries.

When the estate tax exemption was $500,000, there was a concern for almost all people about minimizing estate tax. With an estate tax exemption of $13.61 million, far fewer people need planning to avoid estate tax. The funded B trust from a formula trust provision triggers higher capital gains while not saving any estate tax whatsoever.

This issue was such a concern that the IRS developed a “portability election” to alleviate the need for a formal bypass trust for many people. The portability election allows the surviving spouse to use the deceased spouse’s unused estate exemption. That election can be presently filed up to five years after the first spouse’s death.

What a bypass trust does

The bypass trust is an irrevocable trust with a separate tax identification number. The bypass trust is required to file a separate income tax return each year. Often, the definition of income in the bypass trust utilizes trust accounting rules, which often categorize income from capital transactions during the surviving spouse’s lifetime as capital taxable to the trust and not to the surviving spouse. This will trigger higher income tax.

The problem is that the maximum federal tax rates for a trust are triggered with only about $12,400 of trust income. The maximum individual tax rates for the surviving spouse are only applicable with income over $450,000. Income tax paid through the trust using trust income tax rates will be significantly higher than if paid by an individual using the individual tax rates and tables. The surviving spouse is limited in his or her access to the assets in the bypass trust and pays a higher income tax during his or her life despite the fact that no estate tax is saved whatsoever.

Three techniques are often suggested to fix this situation. Of the three methods often used, only two actually work.

1. Agreement between all the parties.

Some professionals will utilize a simple agreement between the surviving spouse, children or other remainder beneficiaries and the trustee (if the trustee is not the surviving spouse). However, that will almost certainly not comply with your state’s trust law, which defines the appropriate steps or process to modify an irrevocable trust. This typically requires a court order or decanting statute and process (more on decanting below). 

An income tax auditor is not bound by such an agreement in an audit to determine if any basis step-up is appropriate. Some financial institutions will not recognize such an agreement and may not permit trust assets to even be transferred. The trustee, lawyer and other professionals may incur liability if a remainder beneficiary is changed by the surviving spouse or some disagreement follows. This is not really a viable solution at all.

2. Court order.

A court order can typically be obtained under your state’s probate code to change or modify the bypass trust. Great care should be taken not to refer to or cause a termination of the bypass trust. Private Letter Ruling 201932001 provides that the early termination of an irrevocable trust can be treated for income tax purposes as a sale of the assets to the beneficiaries with zero basis. 

For example, if assets worth $6 million are transferred to the beneficiaries, this results in a tax liability of about $2 million in California when the federal and California taxes are combined. A properly filed petition and the resulting court order can result in a full basis step-up for income tax purposes, correction in the definition of trust income to prevent the higher income tax on capital transactions during the surviving spouse’s lifetime and even avoiding the requirement for filing a separate income tax return for the surviving spouse. 

The court order provides much better protection in an income tax audit as it evidences compliance with your state’s probate code or trust law.

3. Decanting.

Some states permit “decanting” the trust to fix the undesired provisions. Decanting is a process where a new trust is created with the desirable provisions. The bypass trust assets are then decanted, or transferred, into that trust by means of discretionary authority under state law. Many states, such as California, do not permit decanting that involves the substantial trust change needed to solve the bypass trust tax dilemma.

One state that does permit decanting to solve the bypass trust issues is Nevada. Check with your state to ascertain if that is permitted. There is no formal court filing, which can be an advantage for someone with a very short life expectancy. A court order compelling the changes to the bypass trust is a very effective tool in the event of a tax audit.

How an 'untimely' disclaimer works

What if the beneficiaries need the assets and are not concerned with waiting for the basis step-up upon the death of the surviving spouse?

They could consider an “untimely” disclaimer.

Internal Revenue Code Section 2518(b) provides that a disclaimer can be filed within nine months of the date of death. If filed, for tax purposes and purposes of the trust administration, the surviving spouse is viewed as if he or she predeceased the first spouse to die. The assets can then flow to the children or other beneficiaries without a negative income tax consequence.

Many people, including professionals and even judges, are not aware that state law may provide a much longer period of time to make a disclaimer. Since an “untimely” disclaimer is made after the IRS nine-month requirement, a taxable gift may result. But, if there is no taxable estate for estate tax purposes, then there is no gift or estate tax liability. This permits the transfer of the bypass trust assets without the potential negative tax consequences of an early trust termination. Note that this choice means that there is no step-up in income tax basis upon the later death of the surviving spouse.