By David Shayne
Since 1998 at least when the federal estate tax exemption was $625,000, a bypass trust (frequently called a “credit shelter trust” or “family trust”) has been an almost invariable component of a married person’s estate plan. Moreover, the customary formulation gears the size of the trust to the deceased spouse’s unused federal gift and estate tax exemption and what’s left is the surviving spouse’s share, typically in the form of a marital trust. Thus, we permit Congress to dictate how much the spouse receives. Moreover, the reduction of the spouse’s share has been dramatic: the 750% increase in the federal gift and estate tax exemption over the past 16 years has shrunk the surviving spouse’s share drastically in all but a few estates. However, often the bypass trust more or less mirrors the marital trust in that the survivor has considerable access to the funds in the trust. Such an arrangement generally eliminates or at least minimizes the couple’s estate tax burden. (Same sex marriage probably will increase the number of no tax estates.) With the advent of a $5 million exemption in 2010 and indexed for inflation ($5.34 million in 2014) it is estimated that no more than 0.14% of Americans will incur a federal estate tax, a slim segment of the population. The other relevant changes in 2010 were reducing the tax rate to 40% from 45% and adoption of “portability”, the ability of one’s spouse to use the deceased spouse’s unused exemption. Thus, while Congress did not quite abolish the federal transfer taxes (estate, gift and generation-skipping), it effectively eliminated them for all but the uninformed and the ultra-wealthy. At the 40% rate, the latter have considerable incentive (and wherewithal) to continue to lobby for abolition or a lower rate as opposed to an increased exemption. Meanwhile the super-wealthy are inclined to employ discounting techniques to minimize their exposure. The ability to pass one’s unused exemption to one’s spouse is a powerful reason to avoid or minimize the bypass trust. No longer is it essential that the less wealthy spouse be given enough property to use his or her exemption in case he or she predeceases the richer spouse. (There is still the advantage of basis increase for the survivor.) For example, Dan dies with $3 million of which $2 million is in his IRA. He leaves $1 million to his children or via a bypass trust and the IRA to Sarah. Through portability, she picks up $3.34 million (2014) additional exemption. Alternatively, Dan leaves everything to a bypass trust, possibly incurs state estate tax and wastes exemption to the extent the IRA is distributed to Sarah during her remaining life. (Caution: the ported exemption will not adjust for inflation, is not usable in most states for estate or generation-skipping transfer (GST) tax purposes, and will be forfeit if Sarah remarries and does not use it for gifts before her second spouse dies. She may, however, acquire exemption from her second spouse.)
Of course, bypass trusts are only one of the many tax motivated trusts that no longer have the same rationale. Lifetime trusts for children, grantor retained annuity trusts (GRATs), charitable lead trusts, and many other types of irrevocable trusts generally required a reason for existence. GST trusts have also become popular ever since Congress placed a limit on the amount eligible. But as with the estate tax, the increase of the GST exemption to the same level as the estate tax and the inevitable proliferation of descendants has made concern about a tax at every generation often academic. Trusts are not only estate tax irrelevant in most cases, but now are radically disfavored for income tax purposes. Accumulated income above about $12,000 a year is taxed at the highest rate, 39.6%. In addition, the Medicare tax takes another 3.8%. Individual taxpayers reach those rates at $200,000, couples at $250,000. Many trusts are not affected as to ordinary income because they distribute it. However, net capital gains over $12,000 in 2014 will be taxed at 20% instead of the individual rate of 15% except for those in the 39.6% bracket and will also incur the 3.8% Medicare tax. For the duration of the trust the beneficiaries risk a 8.8% surtax (5% + 3.8%) on realized gains that they probably would not have incurred on assets in their own name. Similarly, when a beneficiary dies, the assets not includible in his or her estate will not receive a new basis equal to the value at his or her death. Trusts also bear compliance burdens such as preparation of returns and accounts and frequently trustee’s fees.
Why Have Trusts?
Before we abandon or regret the use of trusts, what is their continued relevance?
State Estate Tax
About one-third of Americans are subject to a state estate or inheritance tax. Of the 13 states and the District of Columbia that have an estate tax, the state estate tax on an estate of $5.34 million (exempt from the federal tax in 2014) is usually in excess of $450,000. One way to minimize that tax in a few states is a state bypass trust. Allocating the amount of the state exemption to a trust for the life of the surviving spouse will avoid including the value of that trust at the beneficiary’s death in his or her estate. Another is to move to a state without one (that works but is often not desirable). Still another is to make a lifetime gift but in a couple of states that is only partially effective. Massive gifts will have an effect but lesser gifts generally will not. For example, an Illinois, Massachusetts or District of Columbia resident would need to give away all but $100,000 to eliminate state estate tax. (It is unlikely that anyone would do that much except if he or she acknowledges that he or she is about to die and is still able to make the gift.) Some living trusts create a bypass trust based on the lesser of the unused federal or state estate tax exemption. That may lead to a bypass trust of a mere $100,000. It will save $28,000-$38,000 but perhaps instead of a $100,000 trust the funds should pass to the spouse or children.
A trust with multiple beneficiaries can reduce the tax on ordinary income by distributing it to modest bracket taxpayers. It may be possible to shift the capital gains tax burden from the trust to beneficiaries in lower brackets although this is not commonly done.
Although their origin was in part to escape taxation, there are numerous non-tax reasons for a trust. Among them the most common are:
- By avoiding probate, a trust can transfer assets promptly and efficiently.
- Keeps family’s financial affairs private.
- Managing the funds for immature, disabled or imprudent beneficiaries.
- Control of investment management.
- Continuity of management, not interrupted by death or disability .
- Avoidance of creditors of the beneficiaries.
- Asset preservation in case of divorce and family disputes.
- Saving for advanced education and retirement.
- Avoiding need of a guardian for disabled creator or beneficiary.
- Sheltering real estate and valuable possessions located in another state or country.
- Assuring succession of assets within the family, i.e., grandchildren.
Sam Sample, of Boston, MA, recently left an estate of $5 million. His 2006 will left the amount exempt from federal estate tax to his children and the rest to his wife. When he signed the will the federal exemption was $1 million. Now it is more than $5 million. Result: His widow takes nothing and Sam’s estate will pay $391,600 Massachusetts estate tax. By neglecting to update his will, Sam inadvertently disinherited his wife and prematurely burdened his estate with state estate tax. If he had left $1.1 million that did not qualify for a marital deduction, the MA tax would be $38,800, a stiff marginal rate, which illustrates that the so-called exemption is really a threshold over which the entire net estate is taxed. If he had died a resident of Illinois, the result would have been similar, but the Illinois estate tax would have been $285,714 (a 28.57% marginal rate). Even if he died in a state without an estate tax but owned property in a state that did, a tax in that state may have been due.
We are in a new era in wealth transfer planning, at least for most Americans. Existing estate plans needs to be reexamined in light of the changes in the tax laws. Bypass trusts, generation skipping plans and discounting techniques may not only no longer be needed, but may be detrimental from an income tax point of view. A bypass trust with less than the full federal exemption may be preferable. Many wills and revocable trusts require streamlining. The simplicity intended by Congress with recent tax legislation has complicated the situation for most people and provoked the need for a thorough reexamination.
David Shayne is Of Counsel to Holland & Knight in its Chicago Office.