skip to Main Content

What You Want in Your Living Trust

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.

  1. 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.
  2. 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.

Back To Top