By Nancy Burner, Esq.
For a traditional married couple, the estate planning has become simpler in many ways. Before the estate tax was increased on both the state and federal level, we were fixated on saving estate taxes. Simple techniques like bypass and marital trusts and insurance trusts called ILITs were the gold standard in estate planning. Today many of those types of plans are irrelevant and maybe even harmful in an estate plan.
Bypass trusts are trusts created in the estate of the first spouse to die. So, for example, if a husband died when the exemption was $1.0, his will left $1.0 million in his bypass trust to protect his exemption (the amount he could pass to a nonspouse tax free) and then the balance would be distributed to his surviving spouse tax free. The idea was that when the second spouse died, she would have her own exemption and the monies in the bypass trust would pass tax free to the next generation.
If the exemption was $1.0 (or more) when the survivor died, then both the bypass trust amount and the exemption amount when the second spouse died would escape estate taxation. This is the most common type of estate plan that was utilized in the last 25 years and many clients still have these documents in place. In instances where the first spouse has died, there still exists a bypass trust for the benefit of the surviving spouse. For those couples with these types of estate plan but with assets under $5.25 million, it’s not too late to change them.
But, what if one spouse has died and the surviving spouse is still alive with assets in a bypass trust. Is there more planning to be done?
Assume a couple in 2000 with $1.8 million worth of assets. Husband died and $1.0 million was payable to the bypass trust under his will for the benefit of his wife. According to the terms of the trust: (1) she can have all the income, (2) she is entitled to distributions for her health, education and support, and (3) a trustee can distribution all the trust assets to her for any purpose, even if the trust is depleted. The purpose of this trust was clearly to shield the first million of the estate from estate taxes when the surviving spouse later died but gave the trustee the power to make unlimited distributions to the spouse.
Now also assume the wife has, in the intervening years, protected her own $800,000 from the cost of long-term care by placing those assets into an irrevocable trust. In the meantime, the bypass trust has grown to $1.6 million dollars. There are two glaring problems: Capital gains tax and cost of long-term care.
When the surviving spouse dies, the assets in her irrevocable trust will be counted as part of her taxable estate. If she dies this year, she will have a New York state estate tax exemption of $5.25 million (increasing to $5.49 million in 2019) and her federal exemption is $11.18 million. Clearly, she does not have a taxable estate. Her assets will pass tax free to the next generation. However, the assets in the bypass trust will have a capital gains tax for any growth in principal.
Assuming the capital gain of $600,000 and a capital gain rate of 33 percent, there could be a capital gains tax of just under $200,000. If the bypass trust assets were not in the trust, but in the surviving spouse’s estate, there would be no estate tax and no capital gains tax. In this case, assuming no other facts, it would be best to distribute the assets to the surviving spouse and allow the assets to obtain a “step-up in basis at her death.”
The second problem with the bypass trust is that the broad distribution rights under the trust makes those trust assets available to pay for the spouse’s long-term care. She has protected her own assets, but likely the $1.6 million is available to be spent down. In this case, if the trustee were to distribute the trust assets to the surviving spouse, she could add those assets to her irrevocable grantor trust. She would enjoy the income in the trust, her estate (i.e., her heirs) would get a step-up in basis on her death, and the assets could be shielded for the cost of nursing home care or catastrophic illness after five years.
This same scenario applies in the case of insurance trusts that were created during the life of the first spouse to die. The trust was likely intended to shield the surviving spouse’s estate from estate taxes, but the increased exemptions make the insurance trust unnecessary. There is an income tax return due each year that is a burden in both time and money. There is no step-up in basis at the death of the surviving spouse, and the assets are probably not protected from the cost of long-term care.
While the trusts in this example give the trustee wide latitude in distributing trust assets to spouses, not all trusts are the same. If the trustee does not have the power to distribute outright to the spouse, there may be an alternative way to accomplish these objectives. New York state has a very generous decanting statute that may be utilized to “fix” the trust. It may not be too late.
Nancy Burner, Esq. practices elder law and estate planning from her East Setauket office.