Q. 20 years ago, 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 four 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 sold, even if my children sell them 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 greater than that exemption, your attorney probably suggested the A-B trust plan to preserve the first spouse’s exemption until the death of the survivor of you, to thereby minimize the estate tax. Back then, this was typically a good tax strategy, since assets in excess of the exemption were then 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 usually did not get a second adjustment in tax basis upon the death of the survivor. If those assets later appreciated 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 would be 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 $12.06 million per person for individuals dying in 2022, and will likely increase through 2025 by an inflation factor. Even after year 2025, most observers feel that it will still be significant.
Furthermore, under current tax law, the exemption no longer expires upon the first spouse’s death, provided that the survivor takes steps to preserve it by timely filing an Estate Tax Return (Form 706) and opting to preserve the deceased spouse’s unused exemption amount. This is called “portability”. Hence, the A-B trust split is no longer necessary to preserve it. As a result, couples with assets of significant value can now create or modify their trusts to eliminate these provisions without incurring an estate tax upon the death of the second to die, and without exposure to a later capital gains tax.
Where both spouses are still alive and able to do so, we often recommend that couples modify their trusts to eliminate the older A-B provisions. These A-B provisions sometimes appear in trusts under names such as Survivor’s, ByPass, Marital, Family or Exemption, Trusts. Further, in situations where one spouse has already died, but the survivor still has an older A–B trust in place, there may still be strategies 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 an elder law or estate planning attorney to see whether anything can now be done to address your concerns and avoid the big tax surprise.