About That Irrevocable Trust . . . Change It And Save Tax!
We all know the story. Mom and dad had their trust drawn up years ago. So much of the law related to estates has changed. So much of the law related to taxes has changed. And, so much of the family’s situation has changed. But, like most, mom and dad never sat down with their estate planning attorney to do periodic reviews to ensure their estate planning documents reflected all of these changes. Indeed, the average individual or couple might see their estate planning attorney once every ten years . . . if that.
Once dad died, his “bypass” trust became irrevocable. And, once his trust became irrevocable, that was it. It was set in stone. The family was now stuck with a trust that was not in tune with estate law, tax law, or the family’s circumstances. If they could only have a “re-do.”
The family might want to build in asset protection provisions into the trust. Perhaps the family would like to convert the bypass trust to a Dynasty Trust so as to extend its period outside the estate tax system. Alternatively, the family would like to convert a portion of the trust to a Special Needs Trust for a disabled family member. If only . . .
Enter a legal concept called “decanting.” The term is borrowed from those who consume fine wines. Typically, a fine wine is allowed to “breathe” after its bottle is opened. And, it is common to decant a fine wine from its original container into another container. Decanting of a trust is when the assets of one trust are poured into a new trust. The new trust has terms and provisions that reflect the updates in estate law, tax law, and the family’s situation.
In order for a family to effect decanting, the state in which the trust is administered must have statutes that enable decanting. Less than half of the states have such enabling statutes. According to attorney Steven J. Oshins, a nationally recognized expert on decanting, the three most favorable jurisdictions for decanting are Nevada, South Dakota, and Tennessee. These same three states jockey for top position among asset protection jurisdictions and Dynasty Trust jurisdictions.
Should a family seek substantive changes to an irrevocable trust – including trusts that have been long-since irrevocable – the first step is to transfer the trusteeship to a trustee in a jurisdiction that provides for decanting. The family will then relate the changes they are seeking to the new trustee, who then engages an attorney who will create the new trust into which the first trust’s assets will pour.
It should be noted that each state’s decanting statutes impose certain requirements and/or limitations on any decanting. But, Mr. Oshins has found that the top three jurisdictions mentioned above are flexible enough to accomplish most families’ objectives.
It is also worth noting that a given decanting might come with or without tax consequences; all being dependent on the specific modification made. For example, if a decanting extends the life of the trust – extends the perpetuities period in legal speak – the decanting will trigger what is known as the Delaware Tax Trap. Depending on the family’s circumstances, it might WANT to trigger that trap.
Let’s say that dad died in 1995. At the time, mom and dad’s joint estate was worth about $1.2 million. If dad left his half to mom, she would have an estate of $1.2 million. When mom died, she would only receive an estate tax exclusion of $600,000. This would expose dad’s $600,000 to the 55% estate tax and the tax bill would have been $330,000.
So, instead, mom and dad’s attorney drafted a trust that would fund a bypass trust with dad’s assets equal to the estate tax exclusion amount of $600,000 that was in place at the time. It preserves dad’s estate tax exclusion. Some attorneys use the term “credit shelter” trust instead of bypass trust.
Now, mom has survived dad by 20 years and still counting. Since then, mom’s assets have grown to $2.4 million and dad’s bypass trust has done the same. The total is $4.8 million. Today, mom’s estate tax exclusion is nearly $5.5 million. My, how times have changed. While unforeseeable in 1995, had dad left to mom his half of their joint estate – even with the subsequent growth – mom’s estate would not be subject to estate tax. One will be quick to say that in either case, neither mom nor dad would be subject to estate tax. So, what’s the point? The answer is income tax.
As we recall, when a person dies and assets pass to beneficiaries, the assets receive a new cost basis for capital gain tax purposes – it’s called a “step up.” The new cost basis is the fair market value on the individual’s date of death. For mom, let’s say 2015. Any unrealized appreciation on assets in mom’s estate will evaporate for income tax purposes. For dad, it was 1995. Any unrealized appreciation on assets in dad’s bypass trust will NOT receive a basis adjustment and unrealized tax liabilities remain.
Wouldn’t it be great if we could somehow pull the assets from dad’s bypass trust into mom’s estate? Remember, doing so will not create an estate tax liability. Mom’s combined assets remain below the current $5.5 million exclusion. But, dad’s assets in mom’s estate would receive a full step up in cost basis and side capital gain tax on the unrealized appreciation as of mom’s date of death.
The Delaware Tax Trap – which can occur anywhere – is triggered when a trust is moved to a jurisdiction different from that of its creation, the new jurisdiction has differing estate rules (such as allowable term of a trust), and the trust’s terms have been so changed. The result is the assets of the trust are pulled into the estate of a given beneficiary . . . exposing the assets to estate tax again. That’s the trap.
In mom’s case, though, pulling dad’s assets into her estate does not expose her to the estate tax. But, being in mom’s estate, dad’s assets now receive a step-up in basis. We have intentionally triggered the Delaware Tax Trap to substantially reduce the family’s overall tax liability.
This is just one example of how a properly executed decanting can help a family reduce its tax burden.