B trusts can result in higher taxes during the surviving spouse’s life because trust accounting rules often require capital gains for transactions within the trust to be taxed at the trust level. The highest marginal tax rates for an individual are triggered with $413,000 in annual income and the highest marginal income for a trust is triggered at $12,300 in income. Avoiding tax at the trust level can provide substantial savings.
Upon the death of a spouse, it will likely be a shock to the surviving spouses to hear they no longer directly own half of the assets they thought they did. If the surviving spouse attempts to use the deceased spouse’s one-half of the community property, it may trigger a variety of undesirable outcomes. The B trust requires a separate tax identification number and tax return. One-half of all accounts and assets must be retitled into the B trust, which generates capital gains that may be taxed at the higher trust income tax rates. Finally, the beneficiaries may not receive a step-up in income tax basis upon the death of the surviving spouse. As a result, the beneficiaries or heirs may incur higher capital gains taxes when assets are sold after the death of the surviving spouse. Ultimately, the B trust creates additional income taxes, restrictions and headaches for the surviving spouse, all without saving any estate tax. It’s highly advisable for married couples with a trust created before 2013 to have that trust reviewed to be sure that a marital formula is not used.
What many estate planners don’t realize is that a B trust can actually be modified to prevent higher capital gains income taxes and other harsh results—however, the surviving spouse must act quickly. Despite the fact that the trust is otherwise irrevocable, it can be modified during the surviving spouse’s life. To do so, all of the beneficiaries must agree to the changes. This will likely not be a problem if the beneficiaries all face a higher income tax. (Though it could be a problem if there are children from a prior relationship or if there is a troubled family relationship.)
The best option, if time allows, is to obtain a court order modifying the trust to include the provisions needed to obtain a step-up in income tax basis to avoid the higher capital gains tax. A court appearance is the safest and best way to obtain this result. However, a court appearance requires a petitioned notice to all interested parties and consents from the other heirs. A court date in most counties is typically available 45 days after filing, which, in cases where the death of the surviving spouse is imminent, may not be sufficient time.
Another backup approach to consider is “decanting” the trust, much like you would decant a bottle of wine. Decanting wine is essentially pouring wine from one bottle to another, leaving sediment and impurities behind. To decant a trust, one would “pour” the assets from one trust to another, leaving behind unwanted provisions and including new, desirable provisions. Decanting does not require the time elements of a judge and courtroom, which makes it a good option if health is an issue. However, in California, decanting does not have the same certainty of a court order. Other states, such as Nevada and Kansas, have strategies that may permit decanting or trust modification without a formal court order.
The income and estate tax worlds have been flipped upside down following the rate changes of 2013. Couples with out-of-date B trusts and their heirs and beneficiaries may be in for a financial surprise when they realize that their trust has left them with reduced assets and high capital gains income taxes.
John Goralka is founder of the Goralka Law Firm in Sacramento, Calif. He can be reached at [email protected].