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Out of Date A-B Trusts Appropriate When Drafted
Capital Gains Problem
Situation Where No A-B Trust in Existence

Introduction: My Mom died recently. She had an A-B Trust. The latter (B Trust) was established when my Dad died a number of years earlier. The whole set up leaves us with an estate that is worth about $2 million. With a $5 million dollar death tax exemption, it seems that that A-B Trust set up was worthless. Boy did that attorney who did the Trust soak my parents.–Angry Daughter

Dear Angry Daughter:
Out of Date A-B Trusts Appropriate When Drafted:
It could be worse than you think! I was not privy to the discussion between your parents and the attorney who drafted the Will. Based on your Dad having died “a number of years” ago and a $2 million net worth, I suspect that the A-B trust was recommended to save on death taxes. (Although this article is dated, here’s an explanation of how that works.) The death tax exemption as recently as year 2000 was $675,000. So what the attorney recommended probably made perfect sense at the time. (back to top)

Capital Gains Problem: But here’s the problem. The B Trust holds the assets of the first to die (your Dad). Typically these assets do not gain a step up in basis on the second death (the death of your Mom). Let’s assume for purposes of discussion that when your Mom died the estate held $1 million of securities in the B Trust. Further, let’s assume that when your Dad died they were worth $500,000 and none them have been sold since that time. If you sell them there will be a capital gain for income tax purposes of $500,000. The combined federal and state income tax might be 25% or higher. Assuming 25%, the tax is $125,000. (back to top)

Situation Where No A-B Trust in Existence: On the other hand, if there had been no B trust (your Mom held everything in the A Trust along with her side of the assets), those securities would be revalued for income tax purposes as of her date of death. In the latter scenario that would mean that all of the pre-death appreciation would be forgiven by the IRS. Thus, when you sold them for $1 million there would be no capital gain and no income tax to pay—a $125,000 benefit. Or, in your case as things stand right now, a $125,000 loss. (back to top)

Solution: So how do you correct this problem? A quirk in the law allows the person in charge of the estate (the manager) to file an election with the IRS telling that agency that the estate desires to have the B Trust focus on capital gain tax savings rather than death tax savings. Typically, this election is made when the first spouse (your Dad) died. But in many cases, this is not necessary and can be made when the second spouse dies. The technical term for this is to take the QTip Election on the B Trust. It does require the filing of a death tax return. However, that death tax return is for the estate of the first to die (your Dad), not for your Mom’s estate. (back to top)

Conclusion: Obviously, filing an estate tax return for your Dad’s estate at this late juncture requires you to have all of the asset records for his estate and to be able to establish a value for his assets as of his date of death. Hopefully, (1) that was done by the attorney who handled his estate (you did have one, didn’t you?) and (2) those records are still available. There are a number of potholes that you need to be careful to avoid in following this procedure, but an experienced attorney can help you navigate through them. (back to top)