Family Trust: Is A/B Trust OK?

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Copernicus
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Joined: Thu May 16, 2013 4:38 pm

Family Trust: Is A/B Trust OK?

Post by Copernicus »

I am asking as help for a relative, who has a family trust of the A/B type, written several years ago. Details:
Married couple, Total equity in trust including house, cars, brokerage accounts 4.0 Mil + IRAs of each 0.5 and 1.0 Mil = Total 5.5 Mil.
Beneficiaries: If one spouse dies, the surviving spouse inherits it. If both die, (Grown up) kids will inherit.
California: No estate tax

They are stressed out because they have been advised to immediately change the trust to remove the A/B type trust.
I imagine the following potential scenarios.

(1) If one spouse dies now, the trust will divide into two trusts, 2.75 Mil each. No tax impact since the deceased spouse's portion in trust A is well within the individual exemption. However, the basis of the deceased spouse's trust A will never change.
- The two trusts will continue to grow, and the surviving spouse will continue to be the trustee of both. (Right?)
- When the second surviving spouse also dies, the kids will inherit both trusts.
- The surviving spouse's trust B may owe taxes, only if the money has doubled to greater than 5.4 Mil (current exemption amount) but this trust B will have step up cost basis. That will help reduce the tax impact on the kids.
- Kids will owe taxes on the trust A assets above the current cost basis only when they sell the assets and realize the cap gains, but not otherwise at the time of inheritance because the assets are below exemption limit for individual. (Correct?
- If the kids use trust A to withdraw only say 4% per year from it, the tax impact should be minimized, even though trust A will have lower cost basis than trust B.

(2) If both spouses die now, the kids will inherit the current trust as is, with stepped up basis. As the amount is well below the exemption limit, no estate tax.

It seems that they should change the trust, before the assets grow to exceed the exemption limits. Looking at the total assets though, it is not an emergency since the amount in the trust is way below the exemption limits. Comments?
bsteiner
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Re: Family Trust: Is A/B Trust OK?

Post by bsteiner »

Your terminology is confusing. A is most commonly an archaic reference to a marital or QTIP trust, and B is most commonly an archaic reference to a credit shelter or bypass trust. But we can tell from the context that you're asking whether the first spouse to die should leave his/her estate to the surviving spouse outright (or in a QTIP trust) to get a basis step-up at the surviving spouse's death, or whether he/she should leave his/her estate in a credit shelter trust.

As you point out, the benefit of the first spouse to die leaving his/her estate to the surviving spouse outright (or in a QTIP trust) is that it gets a second basis step-up at the surviving spouse's death.

The disadvantages of the first spouse to die leaving his/her estate to the surviving spouse outright are that it exposes the surviving spouse's inheritance to his/her creditors and future spouses, and Medicaid. Also, while there's portability for the estate tax, there's no portability for the GST tax.

Until the IRS issued Revenue Procedure 2016-49 about a week ago, it wasn't clear whether the first spouse to die could leave his/her estate to the surviving spouse in a marital (QTIP) trust where the estate was too small to require a Federal estate tax return. That would get the basis step-up at the surviving spouse's death, while providing some asset protection (for the principal though not for the income). The IRS has now said (in Revenue Procedure 2016-49) that this is permissible. The estate of the first spouse to die could then make a reverse QTIP election to allocate the GST exemption of the first spouse to die to the QTIP trust. That provides the best of both worlds assuming the surviving spouse's estate doesn't grow beyond his/her estate tax exclusion amount (with portability). However, note that the portability amount isn't indexed for inflation. Also note that there's been a proposal for the last several years to reduce the exclusion amount to $3.5 million.

Alternatively, if they continue with their current plan in which the assets of the first spouse to die go into a credit shelter trust, assuming the trust is well drafted, the trustees can always distribute the trust assets to the surviving spouse, or decant them into a new trust in which the surviving spouse has a general testamentary power of appointment, if they think that makes the most sense. Or they can keep the credit shelter trust if there's a chance the surviving spouse might (with the addition of the assets in the credit shelter trust) have a taxable estate.

So while it's worth considering the choices, I wouldn't treat this as a crisis.
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Peter Foley
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Re: Family Trust: Is A/B Trust OK?

Post by Peter Foley »

Would a solution to this to make the kids primary or secondary beneficiaries to some of the assets (say the IRAs)? If primary, upon the passing of the first spouse the value of the estate would be reduced. If the kids were secondary (contingent) beneficiaries, the surviving spouse could asses the financial situation at the time and decide which (if any) assets could be disclaimed and passed to the heirs at that time, again reducing the estate.
Topic Author
Copernicus
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Re: Family Trust: Is A/B Trust OK?

Post by Copernicus »

bsteiner wrote:Your terminology is confusing. A is most commonly an archaic reference to a marital or QTIP trust, and B is most commonly an archaic reference to a credit shelter or bypass trust. But we can tell from the context that you're asking whether the first spouse to die should leave his/her estate to the surviving spouse outright (or in a QTIP trust) to get a basis step-up at the surviving spouse's death, or whether he/she should leave his/her estate in a credit shelter trust.
Thank you. I was using A and B without realizing that there is a legal meaning/interpretation to each term. I should have used trust no. 1 and 2, instead.
Bongleur
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Re: Family Trust: Is A/B Trust OK?

Post by Bongleur »

bsteiner wrote:Your terminology is confusing. A is most commonly an archaic reference to a marital or QTIP trust, and B is most commonly an archaic reference to a credit shelter or bypass trust.
Why is this archaic? My parents had a family trust, and when one died it was divided into "xxx Family Trust A" for the survivor and the deceased's half is "trust B." The survivor can draw a certain % of the Trust B capital each year, and all of the interest/dividends flow into the survivor's account.

What is a QTIP?
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