Are You Giving Your Heirs an Unanticipated Tax Bill?

Are You Giving Your Heirs an Unanticipated Tax Bill?

Traditional estate plans written under pre-2017 tax laws may generate significant and unnecessary income tax liability for heirs.

The adoption of the 2017 Tax Act raised the federal estate tax exemption to approximately $11.2 million per person and continued to permit portability, i.e., one spouse can use any part of the exemption that was unused by the first spouse to die. The exemption is indexed for inflation, and in 2019 it was raised to a whopping $11.4 million per person ($22.8 million for a married couple). Many clients stopped worrying about estate taxes. However, if a traditional plan remains in place - one that was created to shelter assets from federal estate tax (that might have been up to 55% of the excess over the exemption) by directing those assets to a credit shelter trust - unnecessary capital gains tax may be the result. The reason is that the income tax basis of the assets held in a credit shelter trust is not stepped up in value at the death of the second spouse because the assets are not included in that spouse’s estate.

For example, suppose Ralph and his wife Sandra lived in New Jersey during their married life. Ralph died in 2008 and his will provided for division of his estate into two trusts: one trust, a credit shelter trust, to hold Ralph’s federal estate exemption ($2 million in 2008), and the other, a marital trust, to hold the remaining assets ($1 million). Both trusts were directed to be distributed to their children at Sandra’s death. Neither of the trusts were subject to federal estate tax at Ralph’s death. In 2019, the assets of the credit shelter trust had appreciated to $8 million. Those assets are outside Sandra’s estate and will not be subject to estate tax when she dies. As a consequence, the income tax basis of those assets does not step up at Sandra’s death. If Sandra dies in 2019 and her children sell all the assets, they would pay up to 23.8% in federal income taxes (20% capital gains tax plus 3.8% net investment income surtax) on the $6 million of appreciation in the assets. They would also pay a New Jersey capital gains tax, which is currently 8.97%.

The challenge for clients like Ralph and Sandra is to move assets out of the credit shelter trust and into the survivor’s estate to obtain the income tax-saving step-up when the survivor dies. Since the credit shelter trust is irrevocable, it technically can’t be amended or terminated. However, many states, including New Jersey, have recognized the need to address changed circumstances that make some trusts impractical, outdated or exposed to unanticipated taxation. The good news is that unintended consequences can often be fixed under new state laws.

Here are some strategies to think about:

  1. Terminate the Trust and Distribute the Assets to Sandra. In New Jersey, a non-charitable irrevocable trust may be terminated without court approval, so long as there is consent of the trustee and all beneficiaries, and provided the termination is not inconsistent with a material purpose of the trust. If Ralph created the trust to reduce taxes, a termination would arguably be consistent with achieving his material purpose. If Ralph’s intentions were unclear, or the trustee is not comfortable with a termination without court approval, the beneficiaries could seek a court ordered termination.
  2. Modify or Decant the Trust. There may be reasons to continue to hold the assets in trust for Sandra. She might prefer to have the assets managed by others. Her children might be concerned that Sandra could remarry and they lose their inheritance to a second husband and his family. In these circumstances, a modification of the trust terms to force the assets into Sandra’s estate for income tax step up purposes might make sense. By doing so, because of the increased exemption, an estate tax will not be generated. To achieve this result, the modification would give Sandra, or appoint an independent person to give Sandra, a "power of appointment" to allow property in the trust to be made available to creditors of Sandra’s estate. This would cause the assets to step up at Sandra’s death for income tax purposes.

    The trust could also be decanted, which means that the trustee directs the trust property to a new trust that contains different terms from the original trust. The new trust would still provide the same protections as the old trust, and if Sandra remarried, her new spouse would not have access to the assets. At least 21 states have adopted decanting statutes, including New York. Although New Jersey has not adopted a statute, the New Jersey courts have recognized decanting.

    Note that in some states that have an estate tax, like Massachusetts, a state-only credit shelter trust may still make sense.

As states recognize more remedies for fixing trusts, you may be able to avoid exposure to unanticipated taxes. Of course, your particular circumstances and your state’s laws will dictate the most appropriate strategy. If you would like to discuss, please contact me or other members of our Private Client Practice.

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