Save Your Children from the Loss of Step-up in Basis Caused by Your AB Trust!
by John M. Daley
If you have an “AB” Trust which was created prior to January 3, 2013, you need to immediately schedule an appointment to review your plan with a qualified Estate Planning Attorney, since your Trust might impose a completely unnecessary capital gains tax penalty on your children or other heirs.
Prior to 2013, an “AB” Trust was the most common type of Revocable Living Trust which was created for married couples who did not have prior marriages or children from prior marriages. An “AB” Trust provides that, upon the death of the first spouse to die, the survivor was required to split the Trust into two parts: one-half of the assets of the married couple continued to be held in an “A” Trust for the benefit of the surviving spouse (the “A” Trust or “Survivor’s Trust”) which remained fully revocable, while the other half was required to be transferred into an irrevocable Trust (the “B” Trust or “Credit Shelter Trust”), the principal of which was, with some exceptions, required to be preserved.
The primary reason for the creation of Joint Revocable Trusts was to maximize the Estate Tax Exemption for married couples. Although it was known that this type of plan would create a capital gains tax problem for the couple’s children or other heirs due to the loss of the “double step up” in basis, this plan was common because, for much of this time, the Estate Tax was relatively high, the Estate Tax exemption was relatively low, and the capital gains tax fluctuated. Moreover, during the decade prior to the enactment of the American Taxpayer Relief Act of 2012 (“ATRA”), no one knew whether there would be a “permanent” Estate Tax. Moreover, it was not clear whether the “portability” of the Estate Tax Exemption for married couples which was first introduced 2010 (“portability” meant that the surviving spouse could preserve the deceased spouse’s unused Estate Tax Exemption by filing an Estate Tax Return for the deceased spouse) would be preserved.
With the passage of ATRA by Congress on January 1, 2013, the uncertainty created during the prior decade dissipated. ATRA made “portability” of the unused Estate Tax exemption (which was first introduced in 2011) permanent, continued the $5,000,000 Estate Tax exemption, with an annual adjustment for inflation, and increased the maximum long term capital gains tax to 25% (including a 21.2% capital gains tax and the new 3.8% Medicare Tax). Since the $5 million inflation adjusted exemption is now a “permanent”* part of Estate Tax law, it has been estimated that 99.8 percent of US citizens will never have to pay any Estate Tax at all. [*The prior law included a “sunset” provision, while the new law does not. Consequently, the new law is “permanent” absent enactment of a different law.]
Although AB Trusts are still appropriate in some circumstances (e.g., for couples with children from different spouses or couples with disparate wealth), they are no longer the "standard" type of Trust for married couples, at least in States, such as California, which do not have their own Estate or Inheritance Tax. On the contrary, most married couples in California or other States which do not have a State inheritance or estate tax should not have an AB Trust, since such a Trust will often result in a substantial capital gains tax on property which is transferred to the B Trust upon the death of the first spouse due to the loss of the “double step-up" in basis on the assets held in the B Trust.
In order to understand this problem, you need to know what the terms "basis," "capital gains tax," and "step-up" in basis mean.
The "basis" of property, such as a home or stocks, is the purchase price of the property, plus any “capital improvements” which you make to your home or other physical assets. If you made capital improvements to a property, the increased basis which results is referred to as the "adjusted basis."
The "capital gains" tax is a federal tax (and sometimes a State tax) which is assessed on earnings from "capital assets," which include real property, stock, bonds, precious metals.
A "step-up in basis" refers to the federal tax law provision (set fort at 26 USC Sec. 1014(a)) which provides that the "the basis of property acquired from a decedent is the fair market value of the property determined as of the date of the decedent’s death." [Although this provision is commonly described as the "step-up" in basis rule, the rule can actually result in a "step-down" in basis if the value of the property at the date of death is lower than it was at the time of purchase. However, this is quite unusual, especially with respect to real property which has been held for several years.]
The "double step-up in basis" refers to the two increases in basis to which your children and other heirs would be entitled if your assets pass 1) from one spouse to the other upon the death of one of them, then 2) from the surviving spouse to the children or other heirs.
For example, suppose that a husband and wife purchased your California home as community property forty years ago for $40,000. However, the husband died of a heart attack thirty years later, at which time the home is worth $500,000. The wife then dies ten years later, at which time the home is worth $900,000.
If there is no "AB Trust" and the entire home passes first to the wife upon the death of the husband, the wife would enjoy a full "step-up" in basis for the home to $500,000. Then, upon her death, the children would enjoy a full second step-up in basis of the home to $900,000.
Under an AB Trust, however, the second full step-up in basis for the one-half of the home transferred to the "Credit Shelter Trust" for the assets belonging to the husband would be lost, since the children and other heirs would be receiving one-half of the home from the deceased husband, who died when the home was worth only $500,000. As a result, their basis in the home would be only $700,000 ($450,000 from the wife's one-half of the home and $250,000 from the husband's one-half of the home).
If the children or other heirs were to sell the home, they would owed approximately $47,600 in capital gains and medicare taxes to the federal government and around $26,600 to the State of California, for total tax "penalty" of around $74,200.
In other words, since property which is held in a AB Trust is not entitled to a second step-up in basis, most couples who are getting a Trust for the first time will choose not to use an “AB Trust,” and most couples who do have an “AB Trust” should consult with Estate Planning counsel to ascertain whether they should re-state their Trust to eliminate the AB Trust structure.
Although there are still legitimate reasons to have an "AB Trust" or even separate Trusts (e.g., separate children from different marriages), in many cases it would be far better to use a “Disclaimer” Trust, which allows the surviving spouse the option to “disclaim” a portion of the Estate into a “Credit Shelter Trust” for asset protection purposes, preferably after consulting with his or her financial advisor and Estate Planning counsel.
If you are a widow or widower and have an AB Trust, your options are more limited, but you might still be able to distribute assets out of the Trust or take other measures to protect your heirs from the capital gains consequences discussed in this article.
In either case, if you have an AB Trust, you should immediately schedule a consultation to find out whether your AB Trust is still appropriate for you.
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