Exemption reform makes case for 'trust-busting'

Trust-Busting: Un-planning Your Estate

Teddy Roosevelt used to be called the Trust-Buster because he forced the great railroad combination in the Northwest to break apart. He was the avowed foe of all sorts of trusts and monopolies.

Now the term ''Trust-Buster'' may have a new meaning. Lots of folks find themselves with trusts set up for estate tax savings that they no longer need. What changed? The rules on federal estate taxes.

Estate Tax

In 1997 the federal estate tax exemption was only $600,000. It has moved steadily upward, hitting $1 million in 2002, $2 million in 2006, $3.5 million in 2009 and $5 million in 2011.

Thanks to the "fiscal cliff' the exemption was scheduled to drop on January 1, 2013, from $5.12 million to $1 million. But the American Taxpayer Relief Act of 2012 (enacted on January 2, 2013) set the exemption at $5.25 million, or $10.5 million for couples with proper planning.

Many people who made wills and trusts in the 1990's and early 2000's had plans that were appropriate when the exemption was very low. Many of them involve trusts.

Under the current law these plans are often inappropriate and contain trusts that are not needed. In fact, many married couples have plans that they assume gives everything to the surviving spouse when, in fact, the plans contain formulas referring to the federal exemption that result in the estate of the first spouse to die going entirely to a trust!

Married couples

A common plan for a married couple to have is an A-B trust plan or bypass trust.

Under this type of plan, when the first spouse dies (let's say it's the husband), assets equal to his exemption from federal estate and gift taxes are placed in the first trust. The rest is placed in another trust for the surviving spouse or distributed directly to her.

The widow can receive the income and principal if needed, but at her death the trust assets bypass her estate and go straight to the children or other beneficiaries. The point of the plan is to use the husband's exemption from estate tax on the assets that pass to the first trust. Then when the widow dies, she uses her own exemption on the rest of the assets.

Exemption doubles

The plan effectively doubles the available exemption. It made a lot of sense for many people when the exemption was $600,000 or $1 million or $2 million.

Being stuck with this plan given the current federal estate tax exemption is disconcerting. Estate plans that were very good when signed are now burdensome and unduly expensive because they set up trusts which no longer save any taxes - they just cause extra administration expenses and hassle.

If you have an estate plan designed to take advantage of estate tax exemption and it was done before the exemption hit the higher levels, you need to have it updated right away. Many of my clients are doing this and are happy that they can now have substantially simpler plans.

Simpler Plans

If your spouse or loved one has passed away without updating his or her plan and you find yourself now the trustee or beneficiary of a trust that is not needed, there are ways that you may terminate the trust and end the costs and hassles of trust administration.

Now, not only is the exemption $5.25 million, but the exemption of the first spouse to die is portable meaning that it can be transferred to the surviving spouse and used without the need for a trust.

What if your spouse died years ago? If your own assets plus what's in the trust are below $5.25 million, your family will probably save a lot of income tax if you can get rid of the trust.

Surviving Spouse

When you die the tax basis of your own assets (but not those in the trust) get "stepped up" to their date of death value. If the beneficiaries sell the assets right away, there is no capital gain or loss. Getting assets out of trust and into the surviving spouse's hands will allow the assets to get a step-up in basis on the death of the surviving spouse.

Also, if income is left accumulating in the trust, it incurs income tax at a very compressed rate schedule. Undistributed trust income above $11,950 is taxed at the highest individual income tax rate, which is now 43.4% on interest and 23.8% on capital gains and dividends.

Federal taxes are important, but they aren't the only consideration.

Before you try to bust the trust, you need to evaluate whether a trust is needed to help save state inheritance taxes. Also, you need to consider the creditor's protection it provides, as well as the control it provides over the ultimate disposition of the assets, for example, the ability to leave them to a new spouse. If the trust has tax losses, they may be lost if the trust is terminated, so keeping the trust going may be the better course.

Sometimes, the trust by its own terms can be terminated if it is too small or the costs of its administration are uneconomical. Also, many such trusts include liberal discretion for the trustee to make principal distributions to the beneficiary and this may be a way of terminating the trust.

Even though a testamentary trust is irrevocable, there are ways to terminate an irrevocable trust under Pennsylvania law since the enactment of the Uniform Trust Code if all of the beneficiaries consent.

Bypass Trust

Generally, such a termination requires court approval, but if it can be shown that the continuance of the trust no longer serves the purpose for which it was intended, a non-judicial settlement agreement may suffice. For example, if a bypass trust is used to keep the trust assets from being taxed in the beneficiary's estate and with the $5.25 million exemption, no tax would be due anyhow, the trust's purpose is not being served.

If the opinion of legal counsel is that the trust can't be terminated under Pennsylvania law, there is another possible solution: change the situs of the trust. Many times the trustee can do this, or the trustee and beneficiaries by consent can do this. The trust can be moved to a jurisdiction whose governing law is more liberal or better addresses the facts and circumstances of a particular trust.