by Charles Des Roches, ESQ
THE ALPHABET TRUSTS
You’ve heard of them – you may even have one yourself: the “A-B Trust” – a form of estate planning for married couples that provides for the division of the couples’ revocable trust into two or more sub-trusts upon the death of the first of the spouse to die. These sub-trusts are known by a variety of names: the “survivor’s trust”, the “marital trust”, the “credit-shelter trust”, the “residual trust”, the “bypass trust”, the “marital deduction trust”, the “qualified terminable interest property” or “QTIP” trust”, the “disclaimer trust” … you get the point. And for brevity’s sake, many trusts are often referred to as the “A”, “B”, “C”, and “D” trusts; hereinafter referred to collectively as the “Alphabet Trusts”.
There are various reasons why a married couple’s trust may be set up to provide for the creation of the Alphabet Trusts, but usually they fall under one of two general headings: tax reasons (to avoid or minimize federal estate and gift tax liability in the spouses’ estates), and non-tax reasons (the “blended family” made up of children from the spouses’ previous marriages).
Alphabet Trusts have value as an estate planning vehicle in the right situations. They can, however, be confusing to the surviving spouses after the death of the first spouse and many clients find them complicated to administer. If the reason the Alphabet Trusts are created is to save substantial amounts of money in federal estate tax, then most clients are willing to tolerate the stress that goes with administering them; but if clients do not realize any tax savings, they are not very happy with the confusion and complexity.
On January 1, 2013, the “American Taxpayer Relief Act of 2012” or “ATRA” was enacted, giving U.S. taxpayers the first permanent set of estate, gift, and generation-skipping transfer (“GST”) tax provisions in 12 years. One of the major effects that ATRA will have on estate planning is that most married couples no longer have any tax reason for creating the Alphabet Trusts. (ATRA has no impact on the non-tax reasons for creating the Alphabet Trusts.)
First of all, under ATRA, the lifetime exemption amount (that is, the amount that each of us may pass on to our intended beneficiaries free of federal estate or gift tax) remains at $5 million, indexed for inflation (placing the exemption at $5.25 million for estates of decedents dying in 2013). The increased exemption eliminates the need for most married couples to create a separate sub-trust on the death of the first spouse to die to make use of that spouse’s lifetime exemption amount rather than have all the couple’s assets pass to the surviving spouse and, possibly, be subject to estate tax on that spouse’s death.
In addition to increasing the lifetime exemption amount to a level that is sufficient to shelter most married couples’ entire estate from federal estate or gift tax liability, ATRA has made portability permanent. Portability allows the executor of the estate of the first spouse to die to transfer, or “port”, the deceased spouse’s unused exemption amount (“DSUEA”) to the surviving spouse.
AFTER ATRA – THE SMITH FAMILY
How will ATRA affect a typical married couple? Assume, for example, that Mr. and Mrs. Smith have a total net worth of $10 million. The Smiths have created a revocable trust titled “The Smith Family Trust” for the purpose of avoiding probate administration on the death of the last spouse to die.. Mr. Smith dies in 2013 not having made any taxable gifts during his lifetime that would reduce the lifetime exemption available to his estate. Mr. Smith’s personal representative timely files a Form 706 Federal Estate, Gift, and Generation-Skipping Tax Return with the Internal Revenue Service, on which the executor makes the portability election, transferring Mr. Smith’s $5.25 million DSUEA to Mrs. Smith. The Smith Family Trust continues to operate for the benefit of Mrs. Smith, who still has the power to amend and/or revoke the entire trust. The Smith Family Trust holds assets worth $10 million, and, because it may be revoked by Mrs. Smith, all of that wealth will be included in her taxable estate for federal estate, gift, and GST purposes on her death. However, Mrs. Smith now has a combined $10.5 million lifetime exemption amount that her estate can apply to any transfers at her death, allowing her to pass the entire trust estate to the Smiths’ intended beneficiaries free of estate tax and without the need to create and administer the Alphabet Trusts!
INCOME TAX BENEFITS
In addition to making things easier on Mrs. Smith by dispensing with the need to create and administer the Alphabet Trusts, the beneficiaries will enjoy an adjustment (usually referred to as a full “step-up”) in tax bases of the assets held in The Smith Family Trust to the fair market values of those assets on the date of Mrs. Smith’s death. So, if the beneficiaries later sell those assets either in the process of administering The Smith Family Trust or later, after having received the assets as distributions from the Trust, the beneficiaries will only have to pay income (capital gains) tax on the increase if any, in value at the date of Mrs. Smith’s death and the date of sale. Had some or all of Mr. Smith’s interest in the assets been transferred into an irrevocable, non-amendable sub-trust in order to be sheltered by his $5.25 million exemption amount, those assets would receive an adjustment in their bases to the values of those assets as of his death, but would not receive a subsequent adjustment in bases on Mrs. Smith’s death. If Mrs. Smith lives several years (possibly decades) after her husband’s death and the value of the assets in the irrevocable sub-trust appreciate significantly during her lifetime, they may be subject to substantial income (capital gains) tax on sale.
While The Smith Family Trust hypothetical is a very common one, there may be other considerations that make the decision of whether to create (or continue to with) the Alphabet Trusts model less clear cut. For example, if The Smith Family Trust included Mr. Smith’s interest in stock that was expected to go public and become extremely valuable (thereby pushing the total value of the trust assets well beyond their current $10 million value), it might be a good idea to have that stock transferred into an irrevocable, non-amendable sub-trust where it would be forever sheltered from federal estate tax liability using a portion or all of Mr. Smith’s lifetime exemption. It is these varying fact situations that make it important to discuss your personal circumstances with an attorney familiar with estate planning and gift and estate tax law, as well as with your accountant and your financial advisor.
If you and your spouse (or another married couple you know and care about) currently have an “Alphabet Trust”, you would benefit from meeting with your estate planning attorney to determine whether it is still the right type of trust to meet your estate planning goals. Remember, the time to do this is while both spouses are alive and have the mental capacity to make changes to their estate plan.
This article was intended to address topics of general interest and should not be construed as legal advice.
© 2013 Noland, Hamerly, Etienne & Hoss