The American Taxpayer Relief Act Of 2012: Time To Review Your Revocable Living Trust

An estate plan is a fine-tuned machine, requiring maintenance and reviews in order to keep the documents up-to-date with the law and major life events. Especially considering the enactment of the American Taxpayer Relief Act of 2012, it is extremely important that an experienced estate planning attorney review your Revocable Living Trust if it was drafted before 2013.

The American Taxpayer Relief Act of 2012 (the “Act”) was enacted in January of 2013. While the Act changed many aspects of the tax laws, the major change affecting estate planning was to the individual estate tax exemption amount. A certain amount of every individual’s assets are exempt from federal estate taxes upon death (there is currently no estate tax in California). For example, in 2005 the individual exemption amount was $1.5 million, and in 2008 it was $2 million. However, the Act increased the estate tax exemption amount, bringing the current (2015) amount to $5.43 million for each individual. The Act also adjusts this amount upward for inflation annually. Furthermore, any unused estate tax exemption amount by a deceased spouse is “portable” to the surviving spouse. Therefore, a widowed individual has the potential to enjoy an estate tax exemption amount of $10.86 million upon his/her death.

Prior to 2013 when the estate tax exemption amount was much lower, attorneys correctly advised their clients to execute a certain type of Revocable Living Trust called an “AB Trust.” Under an AB Trust, when the first spouse passes away property is divided into “A” and “B” sub-trusts for each spouse. The deceased spouse’s sub-trust is irrevocable, and the surviving spouse’s sub-trust is revocable. The purpose behind this was so the surviving spouse could enjoy the maximum estate tax exemption amount since “portability” did not yet exist. To illustrate, Husband passed away in 2005. At this time, all assets were valued at $3 million and transferred to wife, who passed away later that year. In this case, $1.5 million of wife’s $3 million in assets would be subject to federal estate taxes. However, if husband and wife executed an AB Trust, then wife would have transferred $1.5 million to each “A” and “B” sub-trust upon husband passing away. Consequently, wife’s assets would pass to her beneficiaries free of estate taxes (capital gains and other taxes may apply).

Today, with such a high estate tax exemption amount coupled with “portability”, AB Trusts are undesirable for most married couples because there are numerous administrative burdens associated with AB Trusts. For example, annual tax returns must be filed for the deceased spouse’s sub-trust, and attorneys and accountants must be involved to value and allocate assets to these sub-trusts upon the death of the first spouse.

The AB Trust structure may also carry negative tax consequences. One negative tax consequence involves capital gains taxes, which is a tax on the gain (appreciation) on the sale of an asset. For example, if husband and wife purchase a home for $200,000.00 and later sell it for $400,000.00, they will pay capital gains tax on $200,000.00 ($400,000.00 minus $200,000.00).

In California, most community property assets receive a “step up” in basis at the death of the first spouse. This means that when a surviving spouse sells an asset, the base value used to determine capital gains tax is the value of the asset on the first spouse’s death, not the date the asset was purchased. For example, husband and wife purchase a home for $200,000.00, and on husband’s death the home is valued at $300,000.00. Wife later sells the home for $400,000.00. Wife will pay capital gains tax on $100,000.00 ($400,000.00 minus $300,000.00). This rationale also applies to beneficiaries of an estate. In the above example imagine wife passes away, the home is valued at $300,000.00, and the beneficiaries sell the home for $300,000.00. The beneficiaries would not pay any capital gains tax because the value of the home receives a “step up” in basis to its value on the date of wife’s death.

On the contrary, with an AB Trust any assets transferred to a deceased spouse’s sub-trust will NOT receive a “step up” in basis upon the surviving spouse’s death. The beneficiaries will pay capital gains tax on the difference between the value of the asset when it was transferred to the deceased spouse’s sub-trust and the value of the asset when it were sold. For example, husband and wife transfer stocks purchased for $50,000.00 to an AB Trust. Upon husband’s death the stocks are valued at $100,000.00 and transferred to husband’s “A” sub-trust. Upon wife passing away, the beneficiaries sell the stocks for $150,000.00 and must pay capital gains tax on $50,000.00 ($150,000.00 minus $100,000.00).

In order to avoid these administrative burdens and negative tax consequences, you and your spouse can execute an Amendment and Restatement of your Revocable Living Trust, converting it to a “Disclaimer Trust.” A “Disclaimer Trust” does not carry the administrative burdens that an AB Trust does – upon the death of the first spouse, the surviving spouse does not need to do anything unless the value of the estate is large enough for tax planning. Furthermore, as indicated above all assets in the “Disclaimer Trust” (excluding any assets disclaimed for tax purposes) will receive a “step up” in basis on the death of the surviving spouse.

However, an AB Trust structure may be desirable for blended families and asset protection reasons. An AB Trust will ensure one’s spouse does not disinherit children from a prior marriage after the parent’s death. Furthermore, when one spouse works in an industry with a high degree of liability, an AB Trust may be desirable because the deceased spouse’s sub-trust is irrevocable, providing asset protection advantages to the surviving spouse.

Consequently, if your Revocable Living Trust was drafted before 2013 you should have an experienced attorney review it in order to avoid any negative tax consequences and unpleasant surprises. If you have any other questions or concerns regarding your estate plan, please do not hesitate to contact the Law Offices of Tyler Q. Dahl to schedule a free review of your estate plan with an experienced attorney.