“How the New $3.5 Million Exemption Amount Affects Your Estate Planning” (Part 2)
Published in the Hokubei Mainichi, Oct. 30, 2009
During the 13 years I have practiced estate planning law, I’ve helped a lot of Niseis. This has been one of the satisfactions of my work.
Other estate planning attorneys and I have shared the observation that Niseis may be comfortably prosperous but are usually not extremely wealthy. I would guess that other people with similar family histories of arrival in this country are richer by comparison. Isseis lost so much wealth during the war. Their children, even in old age, haven’t caught up.
Takeo Babe Utsumi's reflection in the Hokubei on June 20, 2009, about seeking a buyer for his family’s home when the war broke out, rang true for many families, I’m sure. Mr. Utsumi was desperate to find a buyer, for any amount of money, and the buyers knew they had the Utsumi family by the throat because the evacuation was pending.
The same situation affected my family. My grandfather s family owned three nurseries in the L.A. area that they had to sell in a hurry. They were forced to sell all three businesses, along with their full inventories, for almost nothing.
In the 1980s and 1990s, many Niseis followed the best financial planning advice then available and had trusts drafted to reduce their probate and estate tax risks. They were acting wisely at the time. However, given their current likely estate sizes, and the changes in federal tax law, those trusts may need revision to support the comfort and convenience of the surviving spouse after the first death in the couple.
In my Aug. 28 opening column on this topic, I introduced the importance of the relatively high new federal estate tax exemption amounts even for people with relatively modest assets. I began to explain that older trusts may have constricting effects, especially on surviving spouses, that are no longer justified by tax advantages under the new rules.
Trusts written from the mid-1980s through 2001 were mostly of the A-B or bypass type. These were designed to split the estate into two or more separately taxable sub-trusts upon the first death in a couple. They were intended to keep the amount in each sub-trust below the estate tax cap, which was then less than $1 million, or at least to reduce the overall amount subject to federal taxation.
To accomplish this, the surviving spouse would keep control over assets in a survivor’s trust. However, the survivor would lose control, except possibly in the indirect role of financial manager, over assets that flowed into a separate bypass trust upon the first death.
The survivor would receive ongoing income from the bypass trust and could use some of the principal in specified amounts or for certain purposes, but otherwise could only serve as caretaker for those assets until they could be passed on to the next generation.
The trouble is, these trusts were designed to split at fixed points established in advance. They were brittle structures drafted in view of estate tax caps of $1 million or less, so the fixed points are relatively low — for example, everything after the first $600,000 might flow into the bypass trust, or the couple’s community property assets might be evenly split between the two new trusts.
Because of inflation, home value increases, and the federal tax law changes, it no longer necessarily makes sense to split the estate when one spouse dies. Worse, a trust for a deceased spouse generally can’t be changed after the first death.
Consequently, a death this year that triggered the splitting provisions of a 1980s or 1990s-era trust could unnecessarily separate half or some other portion of the marital assets from the direct control of the surviving spouse.
Example: $2.5 Million Estate
For example, consider a couple with a $2.5 million estate. A bypass-type trust might provide that, on the death of the first spouse, half the couple’s community property assets would go into the bypass trust and half into the survivor s trust. The surviving spouse would have full control over the survivor s trust. However, the bypass trust would become an irrevocable, almost unbreakable, container for half the estate, or $1.25 million.
Under this arrangement the bypass trust would have its own tax identification number. Typically the surviving spouse would be the trustee of the bypass trust, and therefore, as its money manager, would have the duty to submit a separate tax return for every year it produced income.
Income from assets of the bypass trust, such as dividends from stocks, or rent from an investment property, would go to the surviving spouse. As trustee of the bypass trust, the surviving spouse could also, for example, sell an investment property that was in the bypass trust and invest the proceeds in something else.
However, the surviving spouse could touch the principal in the bypass trust only for limited purposes: sometimes in no more than a specified amount ($5,000 or 5 percent was typical), or only for reasons specified in the original trust.
Just last year, when the federal estate tax exemption amount was $2 million, this splitting arrangement would have saved a lot of estate taxes if both spouses with the $2.5 million estate died in 2008. With no estate planning the couple’s estate would have had to pay tax at a rate of more than 40 percent on the $500,000 part of the estate that exceeded $2 million, or more than $200,000 in tax payments.
However, if both members of the couple died in 2009, with an exemption amount of $3.5 million, the split into the bypass trust would no longer create any tax advantage.
Despite the tax-time hassles and loss of financial control, that may not seem so bad when there is $1.25 million in the survivor’s trust under the surviving spouse’s full control.
Example: $1 Million Estate
However, consider a couple with a $1 million estate who have a trust that was drafted in 1992, when the exemption amount was $600,000. Suppose one member of the couple dies in 2009, and the old trust sends half the household assets into an irrevocable bypass trust. The surviving spouse now has just $500,000 in the survivor s trust and must place the other $500,000 into the bypass trust.
If the couple s $1 million in assets included a San Francisco house, the house by itself might be worth more than $500,000. The surviving spouse might have to divide ownership of the house to place $500,000 of house value into the bypass trust, which could lead to capital gains tax implications.
The transfer that was required to fund the bypass trust would leave the survivor with full control over some bank and investment accounts plus part of the value of the house.
If the surviving spouse later sold the house, it would take extra paperwork to transfer the two parts of the title, and afterwards the bypass trust would still own the proceeds from its share of the house value. The survivor would have to manage these proceeds on behalf of future beneficiaries, taking only income from the invested proceeds, even if he or she would have preferred to use the principal for other purposes.
For a $1 million estate, a bypass-type trust is now unnecessary because there is no estate tax on an estate of that size whether it splits or remains whole. Trusts of this type, for estates of this size, should now be changed to more flexible trusts.
If you would like to receive emails about the status of the exemption amount and other estate planning issues, feel free to call our office at (415) 584-4550 or (800) 417-5250, and ask to be added to our e-mail list. Upon request, we would also be glad to send you the first article in this series.
The Law Offices of Laurie Shigekuni
San Francisco Office
2555 Ocean Avenue
San Francisco, CA 94132