There are good reasons why you might want to leave part of your estate in trust. Maybe an intended beneficiary is not a good money manager and will blow through your estate if given the chance. Trusts can be used to limit his or her access to trust assets and income.
Trusts can do even more than that. Similar to the corporate form of doing business, trusts can protect assets from the creditors of your beneficiaries.
In addition, trusts can be used to provide for a series of generations, such as to your children for their lives and then, to your grandchildren. This type of design can have the effect of keeping property “in the family” as opposed to winding its way through the in-laws’ families after a generation or two.
There are many other reasons why trusts might be appropriate, but they are not necessarily well-suited to income and estate tax avoidance. This article will explore some basic tax issues which are in play.
History of the Federal Estate Tax Exemption
Check out this chart showing how the federal estate tax exemption amount has risen since 1997:
In just 23 years, the exemption increased from $600,000 to almost $12 million! Not even the stock markets have boomed like this. Moreover, there hasn’t been a down year yet – not even in 2009-2011 when Democrats held the White House and both chambers of Congress.
This massive acceleration in the federal estate tax exemption has changed the tax planning paradigm completely. Think about all those people who made estate plans back in 2008 and earlier. Many of those outdated plans have not only become obsolete, but they are actually tax traps that can easily cost a person hundreds of thousands of dollars, if not millions. Keep reading, and it will become very obvious why this is the case.
Let’s examine a typical trust plan.
Assume Ted Testator has a taxable estate. He wishes to leave all of his estate to his only child, Charles, who in turn will leave his estate to his children (Ted’s grandchildren).
Ted’s estate will be taxed upon his death. If Ted leaves everything to Charles, the same property will be taxed again upon Charles’ death (assuming Charles will also have a taxable estate).
Generation Skipping
To avoid taxing the property twice, Ted can leave everything directly to his grandchildren. This is called “generation skipping.” The IRS is aware of this strategy, and the tax laws permit it to a limited extent. Generation skipping transfer taxes are beyond the scope of this article, but the simple generation skipping plan described above easily makes the point that double taxation can be avoided.
Let’s say Ted does not want to bypass Charles completely. Trusts can be used to skip Charles without really skipping Charles. A typical trust plan for Ted will leave everything in trust, naming Charles as an income beneficiary for life, and distributing the property to the grandchildren outright after Charles dies. Charles is also named as the trustee, and he is permitted to pay trust principle to himself for his health, education, maintenance, and support (HEMS).
For all practical purposes, this type of trust gives Charles virtually complete control over the trust property. It’s like he owns it… but he doesn’t! It’s not part of his estate when he dies, and no estate tax will apply. Mission accomplished… or not?
This is where it gets slippery.
No Step-Up in Basis
While estate tax avoidance is accomplished, Charles does not own the property. It is in trust. This means, the property will not receive a step-up in basis when Charles dies. Basis is an important tax consideration not to be overlooked.
The basis of an asset is often its acquisition price. For example, if Ted purchased unimproved land in 1980 for $1 million and did not make improvements on it, its basis in 2020 is still $1 million – the price paid. If Ted sells the property for $7 million in 2020, there is a $6 million capital gain, and he will have to write a hefty check to Uncle Sam. This is income tax, not estate tax.
Instead of selling the property in 2020, assume Ted dies, and it goes into trust as mentioned above. As a result of his death, the property’s basis will be stepped-up to its fair market value at the time of Ted’s death (i.e., $7 million). If Charles, as the trustee of the trust, sells the property for $7 million, there will be no capital gain. That’s a lot of income tax saved. You can read more about the importance of a step-up in basis here.
So far, so good…
But What about when Charles Dies?
Suppose Charles dies in 2050, when the property – having been put into trust for his benefit – has greatly appreciated and is then worth $20 million. Since he was not the owner upon his death, the property will not receive a step-up. The basis remains at $7 million – the fair market value upon Ted’s death back in 2020. If the grandchildren sell the property after Charles’ death for $20 million in 2050, they will pay a large sum in taxes on their $13 million capital gain.
If Ted would have left the property outright to Charles, rather than in trust, the grandchildren would have enjoyed a step-up in basis upon Charles’ death. They could then sell the property for $20 million without incurring any capital gain tax liability.
But Charles’ Estate will Incur Estate Tax if He Owns the Property upon His Death!
Who says? Although there is plenty of talk about how Congress or the next President is going to stick it the rich, history indicates this is somewhat unlikely.
Who knows what the estate tax exemption amount will be in 2050? It has risen from $600,000 in 1997 to over $11 million in 2018. Perhaps it could be $30-40 million by 2050. It might even be repealed.
The takeaway here is that when property will significantly appreciate over time, the step-up in basis upon death is very valuable and not to be overlooked. Given the way the estate tax exemption has been growing over the last two decades, it is possible that both estate taxes and capital gains taxes can be avoided. The trust, in our example, failed to accomplish that result since it forfeited the step-up in an effort to avoid estate taxes via generation-skipping. In essence, the skip – which was supposed to save the grandchildren millions of dollars – actually cost the grandchildren millions of dollars.
What about 2025?
In 2025, the current $11.58 million estate tax exemption amount is slated to expire. This means that unless Congress takes action to maintain or increase it, it will automatically revert to $5 million (adjusted for inflation) at the end of 2025. This sort of scenario can make people nervous.
For example, if Ted’s estate is currently valued at $8 million, no tax would be due if he dies prior to the end of 2025. If he dies in 2025, his estate will be subject to estate taxes unless Congress does something.
There are two things to note about this situation.
First, it happened before, in 2012. At that time, the exemption was $5 million, and it was going to revert to $1 million at the end of 2012. Congress did not take action as quickly as people had hoped, and in a last-minute frenzy, many wealthy people started gifting away property. Then, on January 1, 2013, before anyone had a chance to die that year, Congress passed the American Taxpayer Relief Act which extended the $5 million exemption amount.
Admittedly, hindsight is 20/20, but much of that gifting frenzy was for naught. Even worse, all those gifts transferred the owners’ basis to the donees. In essence, the step-up in basis was lost and there was no estate tax savings to be derived from the gifts. That’s a double-whammy for calling it wrong!
Another important point to note is that by leaving estate property to Charles outright, rather than in a generation-skipping trust, he will at least have the option to (i) retain it until death for the step-up in basis, or (ii) forego the step-up and gift it to avoid estate taxes on his death. Being able to make the right call at the closest point in time has massive advantages. Charles is much more likely to know the tax landscape in 2050 than is Ted. Unless there is a really good reason, Ted has no business trying to guess what the tax landscape will be 30 – 40 years down the road.
The generation-skipping trust in our example takes away Charles’ option to keep or gift the property. If the property is in trust, there will be no opportunity to receive a step-up in basis, regardless of what the estate tax and income tax landscape looks like in 2050. As has been shown, planning too rigidly too soon can be a very costly mistake.
This is not to say that all trusts are bad. As stated above, there are many good reasons to leave property in a trust. It is also possible to structure trusts in a manner to include property in a beneficiary’s estate. If the trust in our example gave Charles a testamentary general power of appointment over the trust property upon his death, then the property would be included in his estate and it would receive a step-up in basis, while protecting the property from his creditors during his lifetime.
A testamentary general power of appointment is the power to give the property upon death (typically by a will provision) to one’s estate or the creditors of one’s estate (among anyone else). The following is an example: “… in trust, naming Charles as an income beneficiary for life, and distributing the property upon his death to such persons as he shall designate in his last will and testament, provided that such persons may include only my grandchildren and the creditors of Charles’ estate.” (By not allowing Charles to appoint the property to his estate, this language prevents Charles from leaving the property to his spouse and keeps the property “in the family,” as described earlier.)
Again, however, an outright gift of the property to Charles would give him the option of keeping it in his estate to receive a step-up, or gifting it to avoid estate taxes. Sometimes, clients need this flexibility; sometimes, they don’t.
Conclusion
There is no crystal ball when it comes to planning for estate and income taxes. All we have to go on is a track record and the current state of politics. Looking at the chart above, the track record indicates that we should expect the exemption amount to rise substantially over the coming years – maybe even be repealed.
This article demonstrated how old and outdated tax planning strategies can do tremendously more harm than good. Trusts can be very useful, but they can also be very dangerous. Don’t just trust your trust to save you taxes. Verify it.