Tax Issues for the Children

Problem: If you have an A-B Trust which mandates the division of the Trust estate on the death of the first spouse, you are probably creating tax issues for your children or Trust beneficiaries.
If you are a surviving spouse with an A-B Trust which has already been divided, you are assuredly going to leave your children or other Trust beneficiaries with tax issues.
Solution: Yes, there is a legal solution to both of these problems. If you are currently married with an A-B Trust, we can amend or restate your Trust to a more adaptable document. One in which allows you the flexibility of continuing the Family Trust as a Survivor’s Trust only. Or it can be restated to a Simple Family/Living Trust.

If you are a surviving spouse, we can petition the Court for a Court order to effect a dissolution of the B Trust and transfer all assets to the Survivor’s Trust A. Why is taking this action of utmost importance for your heirs? It has to do with capital
gains tax. Let’s use a hypothetical to make the point.

Tax IssuesHypothetical: When Andy died in 2010, Anne as Trustee divided the Trust estate between the Decedent Spouse’s Trust B and the Survivor’s Trust A. At the time of Andy’s death the entire estate was held as community property supported by a Community Property Agreement they had signed. As a result, the basis was stepped-up on all of the Trust assets including the home which was bought in 1990 for $450,000. At Andy’s death the home was valued at $800,000, thus the basis stepped-up from $450,000 to $800,000. Their rental property and stocks, bonds and mutual funds also received a
step-up in basis to fair market value as valued at Andy’s death.

Anne, as Trustee, placed one-half of the home and $400,000 in cash in her Trust A and one-half of the home, the rental property and mutual funds in Trust B. Since Andy’s death the home has increased in value by $400,000 and the other assets have increased in value by $500,000. The total estate, both Trust A and B, are currently valued at about $2.5 million. On Anne’s future death only her Trust A will receive a step-up in basis to negate capital gains tax for the children. None of the assets in Trust B, which is considered a separate entity, will receive a step-up in basis. As a result, when the children liquidate the estate to divide the proceeds, the estate will incur capital gains tax on $450,000.

Presently, the federal estate tax exemption is $11 million plus for Anne as an individual. She hardly needs an A-B Trust to protect her $2.5 million estate from federal estate tax. She no longer needs a Trust B. All it is doing is creating capital gains tax for her children besides additional expenses for tax returns accounting annually. The IRS has a bad habit of not informing taxpayers of this kind of result. It is left to us Estate Planning attorneys to be the messenger of bad news.

But it’s not all bad, there is some good news for Anne. We can fix the Trust B, Mr. Hyde, problem. The great majority of surviving spouses will die without ever knowing they were creating a tax problem for their children and could have done something about it.

We have helped several surviving spouse clients with this problem over the recent years as the federal estate tax exemption increased reducing the usefulness of Trust B. Two clients had La Jolla property stuck in Trust B. This property had tripled and quadrupled in value which would have created significant capital gains tax for the children. In each case we obtained Court orders dissolving Trust B and transferring the properties to their Survivor’s Trust A where they will receive a second step-up in basis on the surviving spouse’s death. This action taken is incredibly important for the surviving spouse in benefitting the family heirs. If no action is taken you could be voluntarily handing over hundreds of thousands of tax dollars to the IRS which could have been inherited without any tax to your family.

Sure, the A-B Trust was useful as a Dr. Jeckyl to defend against federal estate tax for many years. But now, you better watch your backs as a surviving spouse. Trust B, Mr. Hyde, allows the tax man to be hiding in wait.


Have questions about tax issues for the children? Give us a call!