THE ELDER LAW ADVISOR

HOT TOPIC: New Estate Tax Law Requires Consideration
of an AB Trust Amendment for 2010

By Jack E. Stephens, Esq.

The last phase of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) adopted by the Congress and the Bush Administration in 2001 has become a reality. No estate tax for 2010 requires that Trustors consider changes in the estate plan and AB Trusts to insure the increase in basis for capital gains tax avoidance. With no estate tax, the AB Trust formula clauses contained in the Trust may not work the way they were intended. For example, many formulas state that the marital deduction Trust A is to receive the minimal amount so as not to create federal estate tax in the decedent’s estate. The minimal amount would be zero as the Decedent’s Trust B would receive the entire estate.

The Trust formula would need to be corrected so as to allow equal distributions to each Trust. Many do this with the application of community property allocation. However, new IRC §1022 requires that the property which is funded into the Survivor’s Trust be owned by the survivor. Under California law, one-half of community property passing to the survivor is owned by the decedent spouse. This fact could prevent heirs of the surviving spouse from obtaining an increase in basis for capital gains tax avoidance. This would result in a significant income tax effect on numerous heirs of decedents dying in 2010. To avoid this problem, the State Bar publication has advised an amendment to the AB Trust which provides that any distribution to the Survivor’s Trust be made instead to the surviving spouse. Such spouse would then personally transfer such assets to the Survivor’s Trust. This would then satisfy the ownership requirements under new IRC §1022 and the heirs of the surviving spouse would receive the $1.3 Million basis increase.

How important is this in an estate plan?

Hypothet: Flo and Mo have an AB Trust funded with their home and investment accounts with a total value of $3 Million. On Mo’s death in 2010, the AB formula provides that the Survivor’s Trust is funded with one-half of the community property. Such property includes the home with a basis of $400,000 and a declining fair market value of $700,000. On the surviving spouse’s death, the home has appreciated back to $1.2 Million.

Because the home is transferred to the Survivor’s Trust by the formula application, it is questionable whether the children would obtain an increase in basis on Flo’s death to wipe out the appreciation of $500,000 for capital gains tax. If not, the children would receive the basis of $700,000. If they sold the home for $1.2 Million, there would be a capital gains tax on $500,000, the amount of the gain.

However, if Flo and Mo amended their Trust to provide that if a spouse were to die in 2010, any assets to be transferred to the Survivor’s Trust would be transferred to the surviving spouse instead. The surviving spouse would then personally transfer such property to the Survivor’s Trust. This would insure that this property was considered owned by the surviving spouse and satisfy IRC §1022. As a result, the children would receive an increase in basis of $500,000 on the home which entirely wipes out the gain.

Allocation of Basis: If you own more than one appreciated asset and are distributing a particular asset to an individual child, it would be prudent to allocate the basis increase of $1.3 Million to each asset via a Trust amendment. Otherwise your Successor Trustee must make this decision and formally notify the IRS of the allocation. If your Successor Trustee is also a beneficiary receiving appreciated assets, this may cause conflict with other siblings in allocating basis increase.

Hypothet: Clyde has a California residence, a rental property and stock investments with a total value of $2.3 Million. He has three children who will inherit the estate. He bought his residence for $200,000 and it is now valued at $700,000. He is specifically leaving this property to his daughter, Rhonda. His two sons will divide the remainder of the estate in equal shares. The rental property has appreciated from $400,000 (its adjusted basis) to $800,000 and the stock from $100,000 to $800,000. How is the $1.3 Million in basis increase to be allocated? Since he has designated one of his sons, Jim, to be his Successor Trustee and Executor, Jim has the responsibility of allocating the basis increase of $1.3 Million among the assets which has a total appreciation of $1.6 Million. Someone will be bridled with capital gains tax since there is no step-up in basis to date of death fair market value under the 2010 law. This new basis law may continue for assets sold in subsequent years. If Clyde amends his Trust and directs the Trustee as to how basis is to be allocated among his assets, he will take the burden from his son, Jim, and protect him from potential conflict and liability.

Planning Recommendation: Have your AB Trust reviewed to determine if the formula clause properly allocates Trust assets and amend the Trust to comply with the requirements of new IRC §1022.

Will Construction and Omitted Heirs

The decedent mother had two children, a son and daughter. She prepared a Will after her son’s death and left $10,000 to each of the son’s two children and the remainder to her daughter. The decedent did not provide for an alternate beneficiary in case of her daughter’s death.

The Will also included a provision that stated: “Except as otherwise specifically provided for herein, I have intentionally omitted to provide herein for any of my heirs who are living at the time of my demise, and to any person who shall successfully claim to be an heir of mine, other than those specifically named herein, I hereby bequeath the sum of One Dollar.”

The daughter died prior to the decedent leaving children with whom the decedent had little or no relationship. After the decedent’s death, the children of the daughter claimed the residue of the estate under California’s antilapse statute, P.C. §21110. That provision states that if a beneficiary fails to survive the Testator, the issue (children, grandchildren) of the deceased beneficiary take in the beneficiary’s place unless “the instrument expresses a contrary intention or a substitution disposition.” The son’s children relied upon the express declaration of omission previously stated in the Will. They asserted that this provision expressed an intention that was contrary to the antilapse statute. If the antilapse provision did not apply, the son’s children would share in the residue.

The Court held for the deceased daughter’s children based on the finding that they were not claiming as unnamed “heirs” of the decedent but as descendants of a deceased daughter who became devisees by statute. The Court further held that the clause in the Will omitting heirs did not express an intention to prevent a transfer to the children of the deceased daughter.

Planning Recommendation: In light of this case and two previous California cases, clients should specify by name any descendants or heirs that you definitely wish to omit in order to avoid the antilapse statute and this Court precedent.

Trust Contests and Attorney Fees

Case Holding: If a beneficiary instigates an “unfounded proceeding against the Trust in bad faith,” the Court has the authority to assess and charge the attorney fees incurred by the Trustee against such beneficiary’s share of the Trust estate.

In a recent California case a minority of beneficiaries (appellants) attempted to prevent the sale of Trust assets by the Trustee which was approved by a majority of the beneficiaries in conformity with the Trust’s provisions. The Court found that the appellants’ primary motivation in opposing the Trustee’s action was to disrupt the sale by preventing the closing by the due date. The Court found that the appellants created unnecessary delays and asserted disingenuous arguments causing the Trust to incur significant legal expenses in the amount of $226,295. The Court held that the majority beneficiaries would not be disadvantaged by these fees and such fees would be assessed against the shares of the minority beneficiaries who initiated the unfounded action.

Spouse Loses Claim to IRA Benefits in Second Marriage

In a recent California case, the husband had a 401k plan with his employer. In 1994 he rolled the 401k into an IRA account and subsequently transferred other IRA funds into such IRA. The husband married his second wife in 2000 and transferred about one-half of the IRA into another IRA with Schwab and designated his children by a prior marriage as the beneficiaries. The husband died in 2005 prior to his required beginning date (RBD). Both the children and his present wife claimed the IRA proceeds. The wife claimed that ERISA, which requires that the surviving spouse be designated as the beneficiary or that the spouse affirmatively waive such right in 401k plans, extended such protection to 401k plans rolled into IRAs.

The Court held that IRAs are specifically excluded from the ERISA law and, thus, provides no protection for surviving spouses in IRAs. The regulations leave the designation of beneficiaries to the owner of the IRA, in this case the husband.

Planning Tip: If this is a potential issue in a marriage, include the agreement to leave an IRA to the spouse in a Post-Nuptial Agreement. This should prevent an owner IRA spouse from changing the beneficiary designation to children by a prior marriage without notice to the present spouse.

This publication is designed to provide authoritative information in regard to the subject matter covered.

IRS Circular 230 Notice:
Any federal tax advice contained in this communication, including any attachments and enclosures, is not intended or written to be used, and may not be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed therein.