Since the year 2012, estate taxes have become less of a concern for most Americans. This is because the individual estate tax exemption had been raised to just over $5 million dollars. Though the anticipated 2015 estate tax rate will be 40% for any amount exceeding $5.43 million, there would be no federal estate tax applied to amounts under that threshold. However, even with an individual estate under $5.43 million (or a married couple’s estate under $10.86 million) it is still critically important to have a well-drafted living trust estate plan. This will ensure avoidance of capital gains taxes to the greatest extent possible, as well as full use of property tax exemptions. Furthermore, it will avoid expensive and extremely time consuming delays and headaches of going through probate.
Capital Gains and Estate Taxes
With A-B Trusts
In previous decades, a married couple utilizing an A-B living trust, which splits into two sub-trusts upon the death of the first spouse, was a common method used to double the estate tax exemption. This method would favorably capture the estate tax exemption of the first spouse to die, which would otherwise be lost without this type of advance special planning. However, in utilizing the double exemption to avoid estate taxes, the estate assets can unfavorably be subject to higher capital gains taxes. Although property generally receives a step-up in tax basis when it’s owner dies, this could work out unfavorably when assets have appreciated during the time period between the passing of the first spouse, and the death of the surviving spouse. When an A-B (credit shelter) trust is funded, the assets in the “B” credit shelter portion are allocated to the first spouse to die, and the assets receive a one time step-up to current fair market value. However, when the second (surviving) spouse dies, the assets in the “B” credit shelter portion do not receive another step-up in tax basis. So if the property has appreciated during the time period between the deaths of the two spouses, the heirs will have to pay capital gains taxes on this increase if and when they sell the property. Of course, assets in the surviving spouse’s “A” portion receive a step-up at the surviving spouse’s death, thus eliminating capital gains taxes on the sale of appreciated “A” portion assets by the heirs.
As illustrated above, since funding the “B” credit shelter portion can have an unfavorable effect on capital gains taxes, it is often best to avoid the A-B trust split and funding unless it is absolutely necessary to avoid estate taxes on married estates valued between $5.43 and $10.86 million. Another consideration is whether the heirs intend to sell the property upon the parents’ death. If the heirs intend to keep the property forever, then the paramount concern would be estate tax avoidance, since payment of capital gains taxes would not be an issue without a sale.
Capital Gains and Estate Taxes
With A-B Disclaimer Trusts
For these reasons, a flexible A-B Disclaimer Living Trust continues to be the best possible approach for many couples with estates in the $1 million to $10 million range. Unlike many traditional A-B trusts created in the past, which require a mandatory split, the A-B Disclaimer Trust instead affords the surviving spouse the final decision of whether or not to split the trust into two sub-trusts until nine (9) months after the first spouse dies. This conveniently delays the decision, possibly to a much later time, when future estate values, tax rates, exemptions, and goals may be better ascertained. This can save your heirs many thousands, perhaps even millions of dollars.
Other Possible Options
On the other hand, some married couples may wish to restrict the surviving spouse’s access to the entire estate. Such as in the instance where a parent has children from a previous marriage and may not want their surviving spouse (if any) to have the flexibility which an A-B Disclaimer Trust provides, which includes the ability for the surviving spouse to use all of the estate assets in any way they desire. There are also various possible alternatives which may help to secure basis step-up to avoid capital gains taxes, yet still prevent the surviving spouse from exercising complete control over the estate assets. Such methods include a calculated funding of a QTIP “C” trust when a QTIP “C” trust wouldn’t normally be used, and the calculated use of portability elections, both of which entail various uncertainties and potential pitfalls which are beyond the scope of this article. And remember that any “permanent” changes in the tax laws are only permanent until the next time it is changed. Therefore, in most instances a flexible estate plan continues to be the best course of action.
Property Taxes & Exemptions
Finally, careful attention should be paid to property taxes and securing all available transfer exemptions from reassessment. This entails the filing by a successor trustee (or heir) of a Claim for Reassessment Exclusion for Transfer Between Parent and Child, for example. This exemption allows the decedent’s home to be exempt from reassessment upon the death of the owner. Obviously a great benefit if the heirs intend to keep the home. Certain (but relatively generous) deadlines apply when a claim for exemption must be filed. As for other real estate, such as rentals, an exemption of up to $1 million in assessed value is available ($2 million if married couple). All real estate exceeding the exemption will be fully reassessed to full market value. The limited exemption can be allocated in accordance with the heirs’ wishes. So, for example, if the heirs wish to keep one rental property, but sell the other(s), then the claim should be carefully applied first to the property to be retained. As for LLC owned properties, the LLC interests can be held by the living trust. And upon the trustor’s death the underlying LLC property qualifies to obtain a full step-up in tax basis (under IRC 754 election) to eliminate capital gains taxes upon sale by the heirs. However, the State of California currently excludes the LLC titled property from qualifying for the parent-to-child transfer exemption from reassessment, reasoning that an LLC is not a parent. Though the actual law is not entirely clear on this point, careful attention should be paid. For example, the LLC owner may consider executing a “pocket deed”, which secretly transfers the property out of the LLC to the living trust. If it later turns out that the heirs wish to keep the LLC property, and that use of the limited exemption will save them property taxes, then the pocket deed could be recorded [after the parent(s) die]. Alternatively, if the LLC property is sold by the heirs, then obtaining a property tax transfer exclusion is not really an issue.
Conclusion
Estate planning is complicated and requires the use of a competent attorney. Given the complexity, it is easy to see that hiring a paralegal service or discount online company to draft your living trust would be a serious disservice to you and your heirs.
Michael K. Elson is a prominent estate planning, wills and trusts attorney. He is the principal of The Law Offices of Michael K. Elson, located in Encino, which provides estate, business and asset protection planning, including living trusts, LLCs, corporations, probate, and trust administration. He may be reached at (818) 763-8831 or by visiting http://www.LimitLiability.com