Will Your Pre-2011 Trust Create expensive problems for your surviving spouse and children?

A revocable trust written before 2011 might contain provisions that would cause the trust’s beneficiaries expensive tax problems.

Why? To avoid federal estate tax on the first death, many older trusts have an AB formula with a bypass trust. These made sense when the federal estate tax exclusion rate was low. Today, these can get messy. With such an AB trust, when the first spouse dies, an irrevocable trust must often be funded with an amount equal to the “applicable exclusion amount,” which is currently $11.18 million dollars. The applicable exclusion amount is the amount an estate may pass to the heirs free of federal estate tax. This exclusion amount has fluctuated over the decades, and is currently at the highest amount in history.

What does an AB trust mean for us today? It means that if you or your spouse dies with an AB trust in place, an irrevocable bypass might have to be funded with up to $11.18 million dollars. Those funds would be illiquid and the income they generate would be highly taxed. If the funds were passed to the surviving spouse instead of put into the bypass trust, the heirs may find that they are on the hook for federal gift taxes. Trust litigators are awaiting direction from the IRS and the courts, and this has been a hot topic for discussion at most gatherings lately.

Let’s consider an example. A married couple has $4 million in assets, all community property to keep it simple. The husband dies with a bypass trust in place. The trust requires that his $2 million be put into the irrevocable bypass trust. The widow may or may not have access to those funds, and the income generated by those funds will be taxed at a very high rate. If the widow decides not to put the $2 million in the trust, then when she dies the heirs may find that they owe substantial gift taxes, as the IRS may interpret that they made Mom a gift of the amount that was supposed to have been placed into the irrevocable bypass trust.

So what should you do? If you have a trust that has the word “bypass” in it, or if your trust predates 2011, it is time to have an attorney review your trust to ensure that it reads exactly the way you want it to, for today’s circumstances. On the first death do you want all of the deceased spouse’s assets made available to the surviving spouse, or do you want them to be placed into an irrevocable trust? What used to be a typical estate planning formula would now be used only in more complex situations.