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Your Trust Has Stopped Making Sense - What Now?

Hoeper Law Offices has recently assisted a client with respect to a testamentary trust that was established to preserve trust assets for the benefit of the beneficiary until he reached a certain age. A problem arose because principally the trust was funded with physical assets including a personal residence occupied by the beneficiary. However, the trust ultimately ran out of money with which to protect and preserve the residence by the payment of the property insurance and timely payment of the real estate taxes. In order to honor the testator's intent, a discussion was initiated with the idea that the beneficiary could reimburse the trust for those expenses so the trustee could fulfill the "reasonable man" standard, preserve the residence, and try to get the beneficiary used to the concept of contributing toward the preservation of the residence as a part of his living expenses.

Because of changes in the estate tax law, trusts that were created in the past may have made estate planning sense at the time they were drawn up, but may not make sense under the current law. The question of the day is what to do under such a circumstance.

One estate plan that was popular when unified credit levels were lower was the A –B Bypass Trust in which assets equal to the exemption from federal estate and gift taxes are placed in one trust at the death of the first spouse. The surviving spouse would have access to earnings and, if needed, the principle, but at her death the trust assets would pass directly to the children. Assets in excess of the unified credit amount would fund the second trust with designated beneficiaries and be taxed in the estate of the survivor. This plan made good sense for some families back in 2001 when the amount exempt from federal estate tax was $675,000. As the unified credit rose to shelter $2,000,000 in 2008 and the estate tax later ultimately was phased out, the plan made less and less sense in more and more cases. Unless a testator was diligent in revising his estate plan to meet the changing and tax environment, an untoward result could occur.

When the estate tax was set to kick back in at the $1,000,000 level in 2010, Congress at the last minute temporarily raised the unified credit exemption to cover $5,000,000 worth of assets and in January of 2013, it made that exemption permanent and indexed it for inflation. With the inflation index, the exemption now shelters $5,250,000. In addition, under the current law, spouses can inherit each other's unused unified credit exemptions. Therefore, under current law, a couple could shield a combined $10,500,000 from federal estate tax without a bypass trust. However, inheriting a spouse's exemption is not retroactive and, if the spouse died years ago, and the survivor has assets combined with what is in the testamentary trust of less than $5,250,000, the family might be better served by getting rid of the trust. This is so because the tax basis of directly owned assets, but not assets in a trust, get a "stepped-up" basis to the current market value as of the date of death of the testator, which would mean that the ultimate heirs could immediately sell inherited assets without paying any capital gains tax.

Moreover, if accumulated earnings are left in a trust, this can cause an increased tax liability. Undistributed tax income above $11,950 is taxed at the highest individual income tax rate, which, after the January 1, 2013 tax hikes, is 43.4 percent on interest and 23.8 percent on capital gains and dividends. In contrast, the surviving spouse with taxable income of, for example, $125,000 per year would pay 28 percent on interest and 15 percent on capital gains and dividends. Effective tax planning would thus favor distributing almost all of the net income from the trust. However, the expense and inconvenience of having to file a separate tax return for the trust would still be made necessary.

An alternative strategy would be to check whether the bypass trust allows the trustee to distribute assets in kind to the surviving spouse. A trustee may be able to terminate a trust if it is relatively small or if it is uneconomical to maintain, since it could be argued that it would not serve the material purpose of the creator. Even if a trustee refused to cooperate, a circuit judge could be petitioned to effectively terminate the trust in this fashion. Before proceeding with such an action, though, it would be incumbent upon the tax planner to check the effects of so doing under state inheritance tax laws, which are not the same from state to state or year to year.

People who set up irrevocable trusts back when the estate and gift tax exemption was expected to only shelter $1,000,000 on January 1, 2013 may now find that those trusts do not make sense in their current situation and the settling donors may worry about outliving their remaining money. If the donees are cooperative and have not accepted the benefits of the trust yet, it might be possible for them to file a timely disclaimer essentially revoking the gift. This strategy, again, will vary from state to state in accordance with state statutes. As part of the necessary paperwork, gift tax returns might be required commencing the running of the statute of limitations setting the time for the Internal Revenue Service to challenge this.

In conclusion, if the person has employed a trust in his or her estate plan, it is advisable to keep up-to-date with respect to their current situation and existing law with respect to adjusting the trust.

Hoeper Law Offices - Waupun Probate Attorney
512 E. Main Street
Waupun, WI 53963
Phone: (920) 324-5050

The information on this website is for general information purposes only. Nothing on this site should be taken as legal advice for any individual case or situation. This information is not intended to create, and receipt or viewing does not constitute, an attorney-client relationship.

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