A Hidden Tax?

I have two conflicting perspectives when I create estate plans for clients.  First, in drafting the documents, I try to think of every possible contingency in case my clients never revisit their estate plan in the event of changing circumstances.  Second, I try to remind my clients that it is a mistake to believe that estate planning is a one-time event when in actuality it is a lifetime process that should be reviewed periodically.  Personal situations and the law can change over time, leaving clients with what were once state-of-the-art plans that are now outdated.

While it is easy to foresee some possible changes such as the incapacity of a trustee or the death of a beneficiary, it is much more difficult to predict other changes, especially changes in tax law.  The massive change to the estate tax brought by the American Taxpayer Relief Act (“ATRA”) that was passed last year had major impact on existing estate plans.  One such area of that impact involves capital gains tax.

A common estate plan for a married couple is an “A/B Trust.”  Upon the death of the first spouse, the trust splits into a revocable “A Trust” for the surviving spouse’s share of the estate and an irrevocable “B Trust” for the deceased spouse’s share of the estate.  Prior to ATRA, the creation of the “B Trust” was critical in eliminating or mitigating the application of the estate tax (sometimes referred to as the “death tax”).  The creation of the “B Trust” came at a cost: while it helped with regard to the estate tax, it had the potential to create an otherwise unnecessary capital gains tax if there was significant appreciation in securities or real property after the death of the first spouse.  When the federal estate tax was approximately 50% and the state and federal capital gains tax combined was 25%, it made sense to choose the capital gains tax over the estate tax.  

However, in the wake of ATRA, the creation of the “B Trust” is not critical for the majority of families in order to avoid the estate tax.  The result is that instead of choosing between a potentially high estate tax and a lower capital gains tax, the existence of the “B Trust” unnecessarily creates potential additional capital gains tax without having any tax benefit.  The potential capital gains tax is lurking in the “B Trust” and might not be discovered until years after the first spouse’s death.  For clients who still have traditional “A/B Trusts,” they might want to consider one of two options.  
First, if married clients are comfortable with the surviving spouse having the authority to completely change the estate plan after the death of the first spouse, they might want to consider creating a “Disclaimer Trust” which does not require that the trust subdivide into an “A Trust” and a “B Trust” at the death of the first spouse.  This option gives the surviving spouse the power to decide at the death of the first spouse whether the family’s current circumstances and the tax law in effect at that time make the estate tax or the capital gains tax a bigger concern.

Second, if married clients like the idea of the deceased spouse’s share becoming irrevocable to protect the estate planning wishes of the first spouse, they might want to consider creating a “Clayton Election Trust” which allows the surviving spouse to choose the tax treatment of the deceased spouse’s irrevocable trust: either a traditional “B Trust” which focuses on estate tax protection and risks capital gains tax, or a “C Trust” (often referred to as a “QTIP Trust”) which focuses on capital gains tax protection and risks estate tax.  

Even after the death of the first spouse, it is still possible to change the structure of an existing trust to eliminate the traditional “B Trust” and its potential negative consequences.  A detailed trust might include “Trust Protector” provisions that give an individual the authority to modify an irrevocable trust to reflect tax or other legal changes.  If the trust does not have “Trust Protector” provisions, there are several provisions in the California Probate Code that allow for the modification or termination of an irrevocable trust upon petition to the Court under certain circumstances.  

While a good estate plan will attempt to navigate as many possible changes in the law, it is still prudent to have your estate planned reviewed by a competent attorney every few years to make sure that your plan is up-to-date and still reflects your wishes and creates the best possible results for you and your family.  

KRASA LAW is located at 704-D Forest Avenue, Pacific Grove, and Kyle may be reached at 831-920-0205831-920-0205.

Disclaimer: This article is for general information only.  Reading this article does not establish an attorney/client relationship.  Because the law is so complex and everybody’s situation is unique, you should consult with a competent attorney licensed to practice law in your community before acting upon any of the information presented in this article.