Is Your B Trust A Time Bomb?
In the estate planning world, Bypass Trusts, commonly called “B Trusts,” have historically been used to minimize taxes. Recent changes to income and estate tax rates, however, have altered the usefulness of these trusts by creating higher capital gains taxes without providing estate tax savings. As such, existing B Trusts are being called “ticking time bombs” that detonate after the surviving spouse’s death.
Under the old federal estate exemption of $675,000 with 55% federal estate tax, estate planners used a marital deduction formula and A-B Trusts to minimize income and estate taxes. In Community Property states such as Nevada, marital formulas placed the surviving spouse’s ½ community property interest and 100% of separate property into the A Trust. The deceased’s ½ community property interest and 100% of separate property went into the B Trust. The survivor would have unrestricted access to the A Trust income and principal. When the second-to-die spouse passed, beneficiaries and heirs received a step-up in basis that minimized capital gains tax liability.
Since B Trusts were irrevocable and limited the surviving spouse’s access to the deceased spouse’s assets, the marital formula is now creating tax burdens on the surviving spouse and beneficiaries. These outcomes can be expensive and surprising to everyone.
Of primary concern is that trust accounting rules often require capital gains on transactions within the trust be taxed at the trust level, rather than at the surviving spouse’s individual tax rate. While an individual is taxed at the highest marginal rate with $413,000 in annual income for a single taxpayer, the highest marginal rate for a trust is applied at only $12,300 in income.
Under B Trust marital formulas, the death of a spouse triggers a transfer of ½ of all assets into the B Trust. This process can generate capital gains that may be taxed at the higher trust rate. Additionally, beneficiaries do not receive a step-up in basis on assets received when the surviving spouse dies. This leaves beneficiaries owing substantially higher capital gains taxes when selling assets after the surviving spouse’s death.
What may not be obvious is that even an “irrevocable” trust can be modified to prevent these costly results. A surviving spouse can seek consent of all beneficiaries to make changes to the B Trust. By eliminating a B Trust, or reforming its terms, it is possible to avoid tax at the trust level, generating significant savings. Saving the beneficiaries significant taxes is often a good motivator for reaching these agreements.
In Nevada, trust decanting or modification without a court order can avoid these major pitfalls of B Trusts. Decanting is a particularly good option because it does not require court approval and can be done quickly if a surviving spouse’s health is at issue. Alternatively, modifications that ensure capital gains are taxed to the surviving spouse at an individual rate can be inserted to a B Trust. For your consultation on avoiding a “tax explosion” in your estate plan, please call Kling Law Offices today.
