Q. Back in 2001, my husband and I created a Living Trust with provisions to avoid estate tax upon our passing. I believe it is called an A-B Trust. When my husband died two years later, my attorney helped me divide the trust assets between the A and the B portions. The problem: my CPA just told me that the assets we put into my husband’s “B” trust will incur a large capital gains tax when later sold, even if my children defer selling them until after I die. This is a big surprise to me. Does this sound right?
A. Yes. The division of trust assets when your husband died may have been necessary at the time to avoid estate tax, but the trade-off was exposure to capital gains tax as to your husband’s portion upon a later sale.
A bit of background may help explain this: When you both created your trust back in 2001, the estate tax exemption was only $675,000 per person and, unless special trust provisions were in place, it expired upon the death of the first spouse. If the value of your combined estate was projected to be greater than that exemption, your attorney probably suggested the A-B trust mechanism to minimize the estate tax by preserving the first spouse’s exemption, effectively doubling it upon the demise of the survivor. This was typically a good tax strategy, since assets in excess of the exemption were taxed at a rate of 55%.
However, the trade-off in creating the A-B mechanism is that assets funneled into the B sub-trust were usually “frozen” in value, from a tax standpoint, at their market value at the time of the first death. They do not get a second adjustment in tax basis upon the death of the survivor. If those assets later appreciate in value, then upon their later sale – whether by you or by your own children after inheriting the property — all appreciation after the first death is taxed as capital gain. I believe this is your problem, and you are not alone in making this discovery.
Since the estate tax rate in 2001 was then about double the capital gains tax rate, the lower capital gains tax treatment was essentially sacrificed for the greater benefit of estate tax avoidance. At that time, the tax trade-off made sense.
Now, however, the estate tax exemption has increased to $5,430,000 per person, at least for individuals dying in 2015, and is set to increase each year thereafter by an inflation factor. Furthermore, under current tax law the exemption no longer automatically expires upon the first spouse’s death; upon a timely election, the unused portion can be preserved for use by the surviving spouse at his/her demise. Hence, the A-B trust split is no longer necessary to preserve that exemption. As a result, couples with assets up to $5,430,000 (and in many cases double that up to $10,860,000) can now create or modify their trusts to eliminate these provisions without incurring an estate tax, and without exposure to a later capital gains tax.
Where both spouses are still alive we often recommend that couples modify their trusts to eliminate the A-B provisions. These A-B provisions sometimes appear under names such as Survivor’s, ByPass, Marital, Family or Exemption Trusts. In situations where one spouse has already passed on, but the survivor still has an older A–B trust in place, there may still be strategies which can be used to minimize exposure to a later capital gains tax, provided they are implemented on a timely basis. These are complex issues. I recommend that you consult your attorney to see whether anything can now be done to address your concerns and avoid the big tax surprise. If you wish, you may contact our firm to evaluate your situation.