For whatever reason, every year we tend to get a lot of new trust administration clients in November and December. Most people know that if their parent or grandparent had a living trust, they may be able to avoid probate. However, most people don’t know what is involved in a trust administration. We’ve prepared a guide outlining the basic steps to administer a trust.
Estate Tax and Gift Tax
The “permanent” estate and gift tax exclusion amounts from the American Taxpayer Relief Act are indexed each year for inflation. The IRS just released its 2014 inflation adjusted numbers. The 2014 estate tax and gift tax exclusion amounts are:
Estate Tax $5,340,000
Gift Tax $5,340,000
Generation Skipping Tax $5,340,000
Annual Gift Tax Exclusion $14,000
The American Taxpayer Relief Act (ATRA) made “portability” permanent – well, as permanent as anything can be while Congress is still in session.
Under the new law, the applicable exclusion amount for estate tax, gift tax and generation skipping tax is $5,000,000, indexed for inflation. This is the amount you can die with or the total amount you can gift during your lifetime without an estate tax or a gift tax. The indexed amount for 2013 is $5,250,000.
“Portability” allows you to capture or “port over” your deceased spouse’s unused exclusion (DSUE).
What is Portability
If your spouse dies in 2013, and his half of your community property estate is worth $525,000, then his remaining exclusion is $4,500,000 ($5,250,000 – $525,000). If after he dies, you file an estate tax return (Form 706) for his estate, and you make the “portability election,” you can capture his remaining exclusion amount.
If so, when you pass away, the amount you can die with before there will be an estate tax is your exclusion amount plus your deceased husband’s exclusion amount that you “ported over.” In our example, your total exclusion would be $5,250,000 (using the 2013 figure) plus $4,500,000, for a total of $9,750,000.
Portability is a great aspect of ATRA. Congress actually did a good thing with this. Instead of wasting the unused deceased spouse exclusion amount (DSUE), you can port it over and have it at the ready just in case your estate value grows.
Need to File 706 Estate Tax Return
You won’t automatically port over your deceased spouse’s exclusion. You have to timely file a Form 706 estate tax return for your deceased spouse to make the portability election. The same estate tax return can be used to make a QTIP election as discussed in my previous post.
By make both a portability election and a QTIP election on the estate tax return, you will be able to to reap the benefits of a bypass trust, including: 1) preserving the estate tax exclusion of your deceased spouse and 2) significantly protecting the trust assets from creditor claims and subsequent marriage divorce claims – but still preserve a step-up in basis and lower income tax rates for the trust income (see my previous post).
The estate and gift tax was changed in a big way by the American Taxpayer Relief Act of 2012 (ATRA). The applicable exclusion amount, the amount you could gift during your lifetime and the amount you could die with before estate taxes, has been a moving target the last two decades. ATRA made the applicable exclusion amount “permanent.” “Permanent” at least until Congress votes to change it.
The new applicable exclusion amount for gift, estate and generation skipping tax is $5,000,000, indexed for inflation. In 2013, it’s $5,250,000. Under these new gift and estate tax thresholds, most of you will not have to worry about a gift or estate tax. I would say 90% of my Sacramento, Folsom and El Dorado Hills estate planning clients will not have to plan around estate and gift taxes anymore under the new law.
If your estate is comfortably less than $5,250,000, the estate and gift tax won’t be an issue. As a result, the traditional estate tax strategy of including an A/B or bypass trust funding formula in your living trust is no longer necessary and could actually increase your capital gains and income taxes.
A better estate planning strategy for most of you is to include a QTIP (qualified terminable interest property) funding formula in your living trust. With a QTIP funding formula, when the first spouse dies, his half of the estate will fund the QTIP trust. The surviving spouse will be the beneficiary and she can be the trustee – this will give the surviving spouse access and control of the QTIP trust.
Benefits of a QTIP Trust
The QTIP trust provides three significant benefits to the surviving spouse and children.
1. Step-Up In Basis to Reduce Capital Gains Tax. The QTIP trust allows for a step-up in tax basis for the QTIP assets when the surviving spouse dies. This could significantly reduce capital gains tax if the children eventually sell the inherited assets. There is no step-up in basis when the surviving spouse dies with a bypass trust.
2. Asset Protection. The assets in the QTIP trust will be significantly protected from lawsuits and claims filed against the surviving spouse, and, if the surviving spouse remarries, the QTIP assets will be off limits to the new spouse and can be shielded from a divorce claim.
3. Reduce Income Tax. A QTIP trust is considered a grantor trust, which means any income generated from the QTIP trust assets will be taxed at the surviving spouse’s income tax rate, rather than the trust tax rate. This should keep the income tax rate low.
Under ATRA, when a trust’s income is more than $11,950, its tax rate is 39.6% – the same rate as the top individual rate, which kicks in at $400,000. So, unless the surviving spouse is at the top tax bracket, she will save income taxes by using a QTIP trust instead of a bypass trust.
In addition, the new 3.8% Medicare tax also applies to trusts with Net Investment Income more than $11,950. Net investment income includes interest, dividend income and capital gains. It also includes passive income from rentals, business activities, and pass-through entities like partnerships, limited liability companies (LLCs), and S corporations. This could push the trust income tax rate to 43.4% (39.6% plus 3.8%).
The net investment income tax does not affect individuals until their Adjusted Gross Income is above $200,000 or married couples filing jointly with Adjusted Gross Income above $250,000.
As a result of the AFTA and the Medicare tax, in most cases, a QTIP trust will result in significantly lower taxes than a bypass trust.
How To Create a QTIP Trust
Here is what you need to create a QTIP trust in your living trust.
- You must be married. A QTIP trust is funded by a gift from one spouse to another. Instead of an outright gift, it is a gift to a trust.
- You need to have your attorney include a provision in your living trust that gives the trustee authority to make a QTIP election. To make a trust a QTIP trust, the surviving spouse will need to file a Form 706 Estate Tax Return for the deceased spouse and list the assets that will be included in the QTIP trust. The QTIP election is not an all or nothing decision. The trustee can elect all or some of the deceased spouse’s share of the assets to fund the QTIP trust. Most living trusts are written to allocate the share of the deceased spouse’s assets that don’t go to the QTIP trust to a bypass trust.
NOTE: You will probably want to make a portability election on the 706 as well to capture your deceased spouse’s applicable exclusion amount. Portability is a big topic I will write about in another post.
If you are married and have an estate less than $4,000,000, which is 99% of Americans, including QTIP provisions in your living trust can reduce the capital gains tax and income tax and provide significant creditor protection and protect the assets from a second marriage.
My last post was really long. Here is the quick summary.
- The American Taxpayer Relief Act raised the estate and gift tax exemption amount to $5,250,000, indexed for inflation.
- Most or you will now not have to pay estate taxes, so you won’t need a mandatory bypass trust in your living trust.
- Better to leave your assets to your spouse in a QTIP trust or outright. That way you will save your family capital gains and income taxes.
For almost all of you there will be no need to do planning to reduce your estate tax. Congress has done that for you. Instead, do planning to reduce your capital gains and income tax.