Complexity is sometimes a necessary evil in estate planning. However with individual estate tax exemptions now more than $11,000,000, indexed to inflation, and portable between spouses, many families will find that existing complexity in their wealth succession plans is no longer necessary. Potentially, it could be counter-productive. An “audit” of the family’s wealth transfer plan by a qualified estate planning attorney may identify opportunities to simplify or eliminate existing irrevocable trusts and replace complexity with flexibility in your ambulatory estate planning documents. Such an audit might identify opportunities for simplification and efficiency in a variety of contexts. As you consider whether and how to change existing trusts to account for unanticipated tax law changes, you also may wish to ensure that your own estate planning documents incorporate mechanisms of flexibility that will make it easy for future generations to do the same when you are gone. This article reviews a number of contexts in which these issues are playing out in the author’s practice in 2018.
I. Review Existing Irrevocable Trusts
Often, trusts created decades ago to avoid estate tax (when exemptions were $600,000 or $1,000,000) are no longer justified by estate tax concerns. Such trusts actually may be increasing the future income tax or capital gains tax exposure of the family.
A. Old Life Insurance Trusts
Corporate and individual fiduciaries serving as trustees of old life insurance trusts should meet with their advisors and consider whether the trusts have outlived their usefulness. In many cases, the policy held by the trust is small relative to the client’s existing estate tax exemptions, and the costs and hassle of administering the trust no longer may be justified. Where the creator (“settlor”) of a trust is living, a trust can be modified or terminated under Iowa law without court involvement by agreement of the settlor and all beneficiaries. Sometimes families will opt to do this with life insurance trusts that are no longer cost-justified by tax or non-tax factors. Be careful to ensure all contingent beneficiaries (including minor and unborn persons) are properly represented pursuant to the Trust Code. Other solutions may include: (1) distribute the policies out to the beneficiaries (sometimes after the trust has been modified to permit the same); (2) having the trust sell the policy back to the insured who created the trust; or (3) asking the court to terminate the trust because it is too small to justify continued administration.
B. Bypass or Credit Shelter Trusts Created by Predeceased Spouse.
Prior to 2010, almost every estate plan for couples with more than $1,000,000 in assets directed that when the first spouse died, his (or her) “tax-free amount” would be held in a “bypass trust” (also sometimes called a “family trust” or “credit-shelter trust”), usually for the primary (or exclusive) benefit of the surviving spouse. This was necessary under the pre-2010 “use it or lose it” regime of estate tax exemptions. Today, the exemptions are larger and are portable between spouses, so we see far fewer plans employing this strategy. However, many thousands of Iowa widows and widowers have a “bypass trust” of some type that was created when their spouse died under the prior regime. In many cases, these bypass trusts were created solely for estate tax planning purposes, with all other assets passing outright to the surviving spouse. At the time, this was good tax planning. Because the tax law has changed significantly, however, an audit of the family situation often will reveal that such trusts have become a detriment rather than a benefit to the family’s tax objectives.
Because the surviving spouse can now pass $11,180,000 tax free (up from $600,000 or $1,000,000 levels that existed when many of these trusts were created), the estate tax purposes that made these trusts beneficial when they were created no longer exist. If these trusts were primarily tax-motivated, it may no longer serve any purpose. What’s more, the existence of such a trust may be detrimental to the goal of tax efficiency, because the assets in a bypass trust do not receive a tax-free step-up in basis when the surviving spouse dies, and the children will bear capital gains taxes when the trust assets are liquidated after the surviving spouse dies. If these assets were held outright by the surviving spouse (or in a trust over which the surviving spouse had a general power of appointment), however, the assets would qualify for a tax-free step-up in basis at the surviving spouse’s death.
For these reasons, many families are taking a hard look at the terms of existing bypass trusts and at the provisions of applicable law that allow for the modification, termination, or decanting of existing trusts. In some cases, the terms of the bypass trust may authorize the trustee to distribute bypass trust assets out to a surviving spouse during her life, such that the trust assets can receive a step-up in basis. For other bypass trusts, it may be necessary to consider decanting or modifying the trust to provide flexibility for such distributions to be made or to make changes that would cause the bypass trust assets to qualify for a step-up in basis upon the surviving spouse’s death (such as the addition of a general power of appointment held by the surviving spouse).
Trust modifications (or decanting) involve complex legal questions and should not be undertaken lightly or without expert professional assistance. The Trustee needs to understand and limit its own potential liability with respect to any modification or distribution, and a unanimous consent and release signed by all beneficiaries (with minor and unborn beneficiaries represented pursuant to the Trust Code) will be recommended in most situations. Spendthrift clauses and other limitations will impact the options that are available. Competent legal and tax counsel are essential in this process, and the Trustee’s counsel generally should not also represent the beneficiaries with respect to the proposed modification, termination, or decanting. Beneficiaries need to consider, before consenting, that if the bypass trust assets are distributed to their surviving parent, such surviving parent could remarry, develop creditor problems, squander the trust assets, become the victim of elder abuse, or just flat-out change their estate plan in a way that reduces such beneficiaries’ inheritances. These non-tax risks need to be weighed against the benefits of obtaining a new basis equal to fair market value on the date of Mom’s (or Dad’s) death. In short, the answer in many cases may be to leave the trust in place, despite the adverse capital gains tax implications of doing so.
Despite the challenges involved, we are finding that especially where the surviving spouse is in her (or his) late 80s or 90s, many families are unanimously agreeing to implement a strategy that results in a step-up in basis upon the surviving spouse’s death.
II. Upstream Planning Opportunities: Gifts from Children to Parents
Many families have transferred interests in a farm or business to the next generation during life, for estate tax planning purposes. The trade-off in doing so is that the assets held by the children will not receive a step-up in basis when the parents die. Some families are looking at reversing these gifts by having children gift these interests back to their elderly parent. If an elderly parent lives at least a year after receiving these gifts, the gifted assets will obtain a step-up in basis at the recipient parent’s death, even if the parent bequeaths the property back to the gifting child. This strategy makes sense only where the following circumstances converge: (1) a parent reasonably can be expected to live a year; (2) the child is able to spare some of his or her gifting capacity (presently $11,180,000) on gifts back to parents; (3) the child is not worried that the parent will fail to leave the gifted property to the gifting child at death (which could occur if the spouse remarried without a premarital agreement, was the victim of elder abuse, or developed creditor problems related to nursing home expense or otherwise); and (4) the gifting child and the recipient parent have separate legal counsel with respect to these matters.
Another opportunity in upstream estate planning would be for a child to gift assets to a parent, and the parent to place those assets in a credit-shelter trust benefiting the child and his or her descendants. This might be particularly beneficial in circumstances where a child’s marriage was in jeopardy or where a child’s profession involved significant liability risk (for which insurance was an incomplete solution). Those two gifts would need to be independent from each other, and parent and child should have separate counsel with respect to those transactions.
III. Reviewing Wills and Revocable Trusts
A. Simplifying Complex Estate Plans
We are revisiting a lot of estate plans created before 2010, to ensure that they do not create more complexity than is needed to achieve the client’s objectives and that they create flexibility to balance estate tax concerns against capital gains tax concerns. For most Iowans with less than $10,000,000 in assets, estate taxation is now a much smaller concern than capital gains taxation. (I say $10,000,000 instead of $20,000,000 because the estate tax exemptions will be cut in half in 2026, absent an intervening Act of Congress, due to sunset provisions in the 2017 tax act). For many families, it will be better to pass assets outright to a spouse (or to a QTIP marital deduction trust) when the first spouse dies rather than to a bypass trust so that we can receive a second tax-free step-up in basis on all assets when the second spouse dies. Most of our estate plans for couples with less than $20,000,000 in combined assets now postpone tax decisions until after the first spouse has died, either through a Clayton QTIP plan (where there are non-tax reasons for wrapping the surviving spouse’s inheritance in a trust) or a disclaimer plan (where there are no such non-tax reasons for a trust). Both of these approaches allow the surviving spouse and her advisors to weigh estate tax planning factors against capital gains tax factors and make an appropriate tax election after the first spouse’s death, in light of the couple’s financial situation, the legal landscape, and all other relevant factors.
B. Drafting for Flexibility
I entered the practice of law in 1998. Most trusts I reviewed in the early years of my practice were off-the-rack, formulaic, mechanical, and rigid. They generally did not create amendment powers, decanting powers, powers of appointment, or other mechanisms that allow a trust to change as needed to adapt to evolving circumstances. Pre-2000 trusts are largely derived from formbooks and seldom reflect the unique values of the families that created them. Old, rigid trusts have not, in my experience, well weathered the test of time. Since 1998, Iowa has a new Trust Code, and some states (like South Dakota and Delaware) have completely reinvented trust law (in ways I hope Iowa will soon emulate). Trusts have become mobile as states compete to lure them with trust-friendly legal regimes. Fiduciary powers have been divided in many cases with different persons or firms serving investment, distribution, and accounting roles. Estate tax exemptions have risen almost 20-fold, and the income tax and capital gains tax regimes also have changed significantly. In short, the entire landscape has shifted. Ossified trusts have had a hard time keeping pace.
The more I learn, the more I appreciate what I don’t and can’t know. The future is not just opaque, it is inscrutable. The best any estate planner (or family) can do is to create flexible vehicles that embody their values but that can adapt to changing circumstances. Especially with trusts that will last more than a generation, it is important for a family to articulate its values, which will serve as a pole star for future trustees and future generations. It is equally important to equip future generations with the ability to modify the mechanics of the vehicles that serve those values so that these vehicles can adapt to whatever challenges or opportunities the future throws their way.
Trustees must have discretion. Mechanisms must exist to remove and replace trustees. Some person must have the ability to modify and refine (or terminate) trusts as necessary to ensure that they continue to empower the development of each beneficiary’s human potential, while minimizing the potential detrimental effects of inherited wealth on character development and initiative. The audacity to plan for future generations must be tempered by the humility to give future generations the ability to adapt that plan to changing circumstances. Dead hand control must be paired with mechanisms of flexibility.
Paul Morf is a sixth-generation Iowan and second-generation estate planning attorney at Simmons Perrine Moyer Bergman PLC. Paul is a graduate of the Yale Law School, a fellow of the American College of Trust and Estates, and the founding vice-president of the Iowa Academy of Trust and Estates Counsel. He can be reached at firstname.lastname@example.org. Find more information about Paul and his practice at https://www.spmblaw.com/our-attorneys/paul-p-morf.
PLEASE NOTE LIMITATIONS: Please see Important Disclosure Information and the limitations of any ranking/recognitions, at www.fostergrp.com/info-disclosure/. A copy of our current written disclosure statement as set forth on Part 2A of Form ADV is available at www.adviserinfo.sec.gov.