The One Trust Update Everyone Should Consider After the Passing of the TCJA of 2017
More than a year has passed under the the largest change in U.S. tax law since the 1980s. Although dozens of tax and estate planning strategies have popped up over that time, one has stood out as one of the more helpful and most-discussed issues in this new environment. With the substantially higher estate tax exclusion amount under the TCJA, we are able to redirect our focus to other opportunities--primarily the maximization of capital gains tax savings of trust assets. But first, some background:
Prior to 2018, the estate tax exclusion (referred to formally as the "Unified Credit") was only $5.49M per individual. This means that an individual was able to amass a gross estate of up to $5.49M prior to death before his or her estate became exposed to the estate tax (one of the most aggressive taxes in the U.S. tax system--up to 40%). Families with the most simple living trust structures were not able to fully benefit from the exclusion, since the entire estate was usually left to the surviving spouse, who then only had the one $5.49M exclusion (bequests to a surviving spouse are fully exempt regardless). By creating an "A/B Trust," the deceased spouse would leave $5.49 (or less) to an irrevocable trust for the benefit of the surviving spouse (B Trust), with an estate valued at that much less passing to the surviving spouse (A Trust) to use another $5.49M, thus, in effect, doubling the exclusion. Although this effectively removes an additional $5.49M out of the estate (around $2M in tax liability), it does come with a trade-off in the form of a missed capital gains tax-savings opportunity. But first, some more background:
This missed capital gains tax strategy has to do with the "cost basis" of trust assets. Cost basis is the purchase price of an asset, and is subtracted from the subsequent sale price of an asset to calculate the taxable gain. The higher the cost basis, the smaller the gain, the smaller the tax liability. For most families, real estate or investments held for decades in the family have appreciated substantially resulting in quite a bit of unrealized taxable gain. Furthermore, cost basis is also reduced by any amount depreciated (not available for all assets), which results in an even greater gain. (In the interest of thoroughness it should be noted that cost basis can be increased by capital improvements to the property, among other adjustments).
Now that we understand how cost basis works, it should be noted that all or some of that cost basis is reset at death for the next generation. This reset is referred to as a "step-up in basis," or a "stepped-up basis." With this benefit not being universally available, it is up to the prudent and vigilant taxpayer to structure their plan in a manner which maximizes this opportunity. In our simple trust structure (everything being left to the surviving spouse), the law allows a step-up in basis in all trust assets upon the death of the first spouse to die (which is a huge benefit for the surviving spouse). When the surviving spouse dies, the entire trust estate receives another step up in basis for the children. This is informally referred to as a "double step-up."
If you are still following along, you will notice that we have arrived at a decision that needs to be made: Do I keep my Married Simple Trust and get a double step-up? Or do I get an A/B Trust and get the estate tax minimization benefit? You can't have both. Typically estate tax liability stings quite a bit more, and as so, has taken center stage during most of its history until now. Additionally, the A/B Trust has asset protection capabilities for the surviving spouse which has really made the A/B Trust a very attractive option all along.
However, with the unified credit so high, the estate tax is not really a threat for many whom it was a threat previously. Conventional wisdom at this point would dictate that the spotlight shifts away from the A/B Trust back to the Married Simple Trust to take advantage of the double step-up; with the high exclusion taking care of the estate tax. However, the Married Simple Trust lacks the asset protection capabilities of the A/B Trust, thus making the decision a little more complicated. Even in this newer tax landscape, the argument that one should still go with the A/B Trust for asset protection purposes, even with the forgone double step-up, would not be unreasonable.
A relatively uncommon trust structure has elbowed its way to the forefront these last couple years and that is the "A/C Trust." The A/C Trust functions almost exactly like the A/B Trust with the C Trust being an irrevocable trust for the benefit of the surviving spouse (also referred to as a "QTIP Trust"), as well as the B Trust's asset protection capabilities. The one big difference is that the C Trust is included in the gross estate of the surviving spouse (even though the trust is irrevocable and restricted). Why would anyone want to complicate their trust with a separate B-like trust structure and not even enjoy the estate tax benefit? Well, the law allows a double step-up for C-Trust assets. So, what we have with an A/C Trust is essentially a trust structure with the asset protection capabilities of an A/B Trust, but the double step-up in basis capability of the Married Simple Trust--the best of both worlds. Well, almost. The A/C Trust does not have any estate tax mitigation characteristics, but with an estate tax exclusion as high as this unprecedented $11.4M and rising, this lack is not a concern at all. Yes, the entire estate is included in the gross estate of the surviving spouse, but for 99% of us, this is simply not a problem.
However, the issues raised by the TCJA are not so clearly defined and addressed: When the TCJA was passed, it only had a 7-year lifespan. U.S. Senate bylaws prohibit the chamber from voting on any bill which adds to the federal deficit for more than 7 years. With the TCJA meeting that criteria, the law is scheduled to "sunset" (or revert) back to 2017 law in 2025 (adjusted for inflation, of course). So, an A/C Trust makes perfect sense for a married couple where both are guaranteed a demise in the next 7 years. However, with death obviously being an uncertainty, we need some additional flexibility built into our A/C Trust. Enter the Clayton Election.
The Clayton Election stems from a 1992 case where the surviving spouse of a Texas estate was essentially able to choose (per the terms of the trust) how much of the estate was to be transferred into the C Trust (QTIP Trust). Prior to 1992, such a decision had to be made prior to the death of the first spouse and memorialized in the trust instrument (with the lower courts holding such a power of the surviving spouse to be too broad). Under a Clayton Election, the surviving spouse is able to sit down, do the math, and effectively create the ideal tax structure for the family. Is there an estate tax problem that needs to be addressed? Then minimize the transfer of assets into the QTIP Trust. Is the estate beyond any danger of the estate tax? Then utilize the QTIP Trust to enjoy a double step-up for all trust assets. It is completely flexible. Furthermore, not only is one able to choose how much goes into the QTIP Trust, they are able to choose which assets go into the QTIP trust. Asset Protection, income, and liquidity are all considerations when choosing what goes into the QTIP.
A double step-up in basis could mean hundreds of thousands of dollars of tax savings for your children. With the driving intent of estate planning being the preservation of legacy, the consideration of a trust update to embrace the Clayton Election and QTIP funding is essential.
*Note that issues of credit portability and other planning considerations were intentionally omitted as beyond the scope of this post.