When Will Modifications of a By-pass Trust Be Respected for Basis Step-up?

• Publication year: 2020
• Author: By Robin L. Klomparens

When Will Modifications of a By-Pass Trust Be Respected for Basis Step-Up?

By Robin L. Klomparens¹

I. EXECUTIVE SUMMARY

The Tax Cuts and Jobs Act ("Act"), increased the basic exclusion amount under Internal Revenue Code ("IRC") section 2010(c)(3) from $5 million to $10 million indexed for inflation after 2011. The Act is scheduled to sunset in 2026, reducing the exclusion amount to approximately $6 million. As it is now, the basic exclusion amount is far greater than it ever was or was anticipated to be. Moreover, portability is also now available which no longer necessitates the use of a bypass trust ("B Trust") on the first death to utilize the first spouse's exclusion amount.

Due to the higher exemption amounts and portability, most clients no longer need a B trust to avoid estate tax on the second spouse's death. Assets in a B Trust do not receive a step-up in basis on the second spouse's death. Using B Trusts also increase administrative costs. Hence, practitioners often propose termination of a B Trust if it is anticipated that no estate tax will be due. There are various methods used to terminate or modify a B Trust, but which of these will be respected by the Internal Revenue Service ("IRS")? Presumably the terminated assets will be included in the surviving spouse's estate for estate tax purposes but is a step-up conditioned on the method of termination or modification?

A distribution agreement, executed by the trustee and all beneficiaries, is often used, to modify or terminate and transfer assets to the surviving spouse. These agreements are also often used to modify or terminate trusts in settlements. Absent agreement, California law arguably requires court approval to modify or terminate an irrevocable trust.

Regardless of the method used to terminate the trust and transfer the assets, there will be inclusion in the surviving spouse's estate and, therefore, estate tax. But if the surviving spouse's assets exceed the exclusion amount on death, do the assets receive a step-up in basis? Because of this uncertainty, many practitioners terminate B Trusts only with court approval. Moreover, other court-ordered modifications can be used to achieve a step-up, such as adding a general power of appointment to a B Trust. Since a court order terminating or modifying a B Trust is binding under California law, a step-up should result.

The IRS should provide guidance to confirm that any assets in a B Trust included in the surviving spouse's estate on death for estate tax purposes result in a step-up in basis. Specifically, guidance should specify which modification techniques allow a step-up in basis on the assets previously held in a B Trust on the surviving spouse's death and which, if any, of these methods do not achieve this result.

II. BACKGROUND

A. Portability

The ability to port the unified credit between married persons was originally enacted for only two years by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 ("TRUIRJCA").² It was effective January 1, 2011, and was set to expire on December 31, 2012, until President Obama signed the American Taxpayer Relief Act of 2012 ("2012 Act") into law on January 2, 2013.³ The 2012 Act made portability a permanent option for married couples.⁴ Accordingly, when a decedent is survived by a spouse, assuming death on or after January 1, 2011, the amount of the unified credit available to that decedent's surviving spouse's estate, for gift and estate tax purposes, includes any unused credit amount of the predeceased spouse, assuming a proper and timely portability election is made.⁵

Upon an individual's death, the decedent's remaining lifetime exclusion amount is utilized to reduce that deceased person's taxable estate. The lifetime exclusion amount for gifts and transfers on death is adjusted each year for inflation.⁶ For 2019, the exclusion amount is $11,400,000.⁷ Therefore, married couples, on or after January 1, 2011, can transfer, or port, any amount of the lifetime exclusion left unused on the death of the first spouse ("deceased spouse") to the surviving spouse.⁸ Accordingly, the surviving spouse is then left with the deceased spouse's unused exemption ("DSUE") in addition to his or her own lifetime exclusion amount.⁹

The primary purpose of estate tax portability is to streamline the use of the first spouse's lifetime credit amount without using a B Trust to hold the deceased spouse's remaining exclusion amount. Prior to portability, utilizing the deceased spouse's exclusion amount required drafting and administering a B Trust. Also, utilization of the exclusion amount was more complicated with transfers of certain assets, such as retirement benefits. Today, the portability provisions reduce the need for many surviving spouses to form and fund a B Trust on the deceased spouse's death, for estate tax purposes.

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B. The Unified Credit Under the Tax Cuts and Jobs Act of 2017

Formally called "An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018," the Act represents the most dramatic overhaul to the nation's tax law since the Tax Reform Act of 1986.¹⁰ In terms of estate and gift tax, the Act allows taxpayers to increase gifts during life and in bequests on death—without gift or estate tax—by doubling the exemption amount from $5 million to $10 million.¹¹ Under the Act, the transfer tax provisions relative to estate and gift tax are only effective for eight years (from January 1, 2018 to December 31, 2025), in the absence of congressional action.¹² After 2025, these provisions sunset and the exclusion amount returns to $5 million (but with indexing will be approximately $6 million).¹³ As a result, the lifetime exclusion amounts of somewhere between $6 and $11 million or more alleviate the need for most surviving spouse's to fund a B Trust to capture the deceased spouse's lifetime credit amount.

C. The Effect of Portability and the Increased Lifetime Exclusion Amount

Coupling the portability provisions with the larger lifetime exclusion amounts has caused a paradigm shift in drafting because, often, there is no need to draft estate plans with B Trusts. Accordingly, practitioners today are focusing on income tax planning and achieving a step-up in basis on death of both spouses.

Prior to the enactment of portability, forming a B Trust for the deceased spouse's estate was necessary or the deceased spouse's exclusion amount was lost forever. The B Trust also allowed the assets funded within such a trust to grow estate tax free to further minimize estate taxes on the surviving spouse's death. However, those assets do not receive a basis step-up upon the surviving spouse's death.

Hence, many clients today, no longer need a B trust to avoid estate tax on the second death. In addition to increasing administrative fees and costs there will be no step-up in basis achieved on any appreciating assets held in the B Trust on the second spouse's death. So, many practitioners are proposing to their clients who are unlikely ever owe estate tax that they terminate or modify their B Trust to maximize the chance that the assets receive a step-up in basis on the surviving spouse's death.

III.WHERE CALIFORNIA LAW ALLOWS TERMINATION AND/OR MODIFICATION BECAUSE FEDERAL LAW MUST RESPECT STATE LAW—A STEP UP IN BASIS SHOULD OCCUR ON ANY ASSETS...