law offices of merwyn j. miller
191 calle Magdalena, suite 270 ē encinitas, San Diego County, ca  92024 ē 760-436-8832

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A-B Trusts: Donít Give Away the Capital Gains Step Up!

A-B Trusts Explained
Necessity of Periodic Review
Capital Gain Explained
Step Up for Decedentís Trust
Methods to Terminate Decedentís Trust
Avoiding Capital Gain on Decedentís Trust after Death

Dear Mr. Miller:

Introduction: I am a widower. My spouse died several years ago. We had an A-B Trust created many years ago to avoid probate and to avoid death taxes. I own my home in a nice part of the Bay Area, worth about $1.5 Million, $750,000 in cash and another $750,000 in securities.

I just pulled the trust out of storage (it took me a long time to find it as I had not looked at it since it was written in the 1990's). I am thinking that this A-B Trust is not doing anything for me anymore. I donít want to do anything that will harm my children but how do I get rid of it?

Senior with Kids

Dear Senior:

A-B Trusts Explained: For our readers who are unfamiliar with the term A-B Trust, letís review. This term usually refers to a Living Trust that divides into two pots after the first spouse dies: the A Trust (or Survivorís Trust) and the B Trust (or Decedentís Trust, Bypass Trust, Family Trust). In many cases, at the first death, half of the estate goes into each side. There are many different ways this type of trust can be written but typically, the survivor can use the Survivorís Trust any way he/she wants, to the extreme that means taking it to Las Vegas and putting it all on black 8. The Decedentís Trust is a true irrevocable trust. Most often, the survivor is entitled to all of the income from it and can get to the principal if needed to maintain his/her quality of life. (back to top)

Advantages: So what are the major advantages of this type of trust. Because, in the eyes of the IRS, the Decedentís Trust is not ďownedĒ by the survivor, it is not subject to death tax when the survivor diesĖonly the Survivorís Trust is subject to that tax. If the Survivorís Trust (and any other assets owned by the Survivor and held outside of the trust) is less than the death tax exemption, then there is no overall tax. (And keep in mind that there is rarely a death tax on the first death.) Also, assets held in a Living Trust, of which an A-B Trust is one type, typically will avoid probate court proceedings on the second death. (back to top)

Necessity of Periodic Review: The problem occurs when the trust is not reviewed periodically by the coupleís estate planning attorney. That appears to be what has occurred in your case. When written in the 1990's, the death tax exemption was no more than $650,000, $600,000 in 1995. Depending on your net worth at that time and your projections for the future, you may have been appropriately concerned about death taxes. If you had been worth $850,000 in 1998 and you had both died then, the A-B Trust would have saved somewhere around $80,000, a significant sum to be sure.

However, that death tax exemption has steadily increased to it present $5.49 million. If you think that there is no rational way the combined estate (Survivorís Trust, Decedentís Trust, and any assets you own outside the Trust) will be worth more than that amount when you die, then getting rid of the Decedentís Trust may be appropriate. (back to top)

Capital Gain Explained: The major advantage of rolling the Decedentís Trust assets into the Survivorís Trust has to do with income tax capital gain. As most of our readers know, capital gain is computed on the difference between the tax basis of the asset (generally the purchase price) and the sale price. If the asset was purchased for $10,000 and is sold for $100,000 the capital gain (what you and I might call the profit) is $90,000 and, potentially, you pay some tax on that (at the 20% rate that would be $18,000). But if you die before it is sold, the IRS forgives the pre-death appreciation (technically referred to as stepping up the basis to the fair market value at the date of death). So, if the same asset you purchased for $10,000 is worth $100,000 when you die and whomever inherits from you sells it for that price, there is no capital gain and no tax to pay. Why: because the basis was ďstepped upĒ to $100,000 when you died and 100,000 - 100,000 is zero.! At a combined Federal and State rate of, say, 20% thatís a saving of $18,000. (back to top)

Step Up for Decedentís Trust: But, and this is a major one, assets in the Decedentís Trust generally do not receive a step-up. Assume in your case that the house is in the Survivorís Trust, the securities in the Decedentís Trust, and the cash split half and half (this is a typical approach when the first spouse dies). Assume those securities were worth $200,000 when you bought them and you were a buy and hold investor. If you die with them worth $750,000 and your children liquidate them the tax, at the 20% combined rate, would be $110,000 (750,000-200,000 x 20%). However, if you can roll the Decedentís Trust into the Survivorís Trust before you die, that tax goes awayĖa savings of $110,000 to your children! So this approach can be huge. (back to top)

Methods to Terminate Decedentís Trust: How does one do this? There are a number of ways, some easier than others. Most can be done only before death while some can often be done after the death of the second spouse. In some cases the Decedentís Trust can be terminated by the Trustee on the basis that all of the assets in that trust are needed to maintain the quality of life of the Surviving Spouse. The assets are drawn out and used. The more appropriate way to do it is to obtain a court order on that basis. Obviously, the latter is more expensive than the former. (back to top)

Avoiding Capital Gain on Decedentís Trust after Death: After death, often, but not always, a death tax return for the first spouse to die can be filed indicating that the Decedentís Trust will be focusing on capital gain tax savings rather than death tax savings (this is called the QTip election). See Step Up in Basis with A-B Trusts.

Conclusion: Obviously, there can be disadvantages and all of these techniques can be tricky maneuvers. So you want the advice and assistance of a highly competent estate planning attorney before you go down this road. (back to top)

March 6, 2017