Review Your Living Trust: Older Ones May Need Revision

Many couples created Revocable "Living" Trusts before the 2001 changes in the tax law, which increased the personal estate tax exemption many-fold over what it was in earlier years. Just before the new law, the personal lifetime exemption was $675,000. For persons dying in years 2004 and 2005, the exemption has been increased to $1.5 million, and the amount of this exemption will increase still further during the remaining years of this decade.

Many of these older trusts contain directions to split the trust estate into mandatory sub-trusts upon the death of the first spouse. This mandatory split was usually designed to preserve each spouse's personal exemption, and thereby reduce or eliminate estate taxes over the span of two deaths; the ultimate goal was to transmit the maximum gift to the couple's remainder beneficiaries, usually their children. However, these trust provisions directing the creation and funding of sub-trusts often still assume the existence of the older, lower exemption amount. In the current climate, these trust provisions may now: (a) no longer be necessary, (b) may undermine the couple's goal to leave to the surviving spouse full access to the couple's entire estate, and/or (c) may now only be appropriate to much larger estates.

In the Living Trust document, the Exemption Sub-Trust is sometimes labeled "Credit Shelter Trust," "Marital Trust," "Family ByPass Trust," "ByPass Trust," or the "B Trust." All have in common the general requirement, following the death of the first spouse, of a mandatory allocation to this sub-trust of the deceased spouse's share of marital and separate property up to the full amount of the applicable exemption. With the increase in the personal exemption, these sub-trusts may no longer be necessary. In a word, these splits may now leave the surviving spouse with only restrictedaccess to one-half (or more) of the couple's resources without a corresponding tax benefit.

Example:A married couple with an estate worth $1 million who created a living trust back in 2000, when the estate tax exemption was only $675,000, would have been well advised to direct a portion of the estate into an exemption sub-trust upon the death of the first spouse in order to eliminate estate taxes. However, the tradeoff would have been that the survivor's access to those assets would have been restricted. Now, with the recent dramatic increase in the amount of the personal exemption, this same couple today might well consider eliminating the requirement of funding an exemption trust and instead leave everything to the survivor in a survivor's trust. In this way, the survivor would continue to enjoy full, unrestricted use of all of the couple's assets as before.

While trust splits and sub-trust funding can still be very important in larger estates in order to minimize estate taxes, there are nevertheless trade-offs. In smaller to medium sized estates, where such tax-driven "splits" may now be unnecessary, unanticipated problems can arise. For example: (1) To the surprise of the surviving spouse, the survivor's access to the assets in the Exemption Sub-Trust will usually be restricted, so that he or she can only access the incomegenerated from the assets (absent special circumstances); (2) the allocation of the personal residence between sub-trusts may result in the partial loss of the capital gain tax exclusion upon later sale of the home; ( c) the Exemption Trust requires good record-keeping, the filing of separate income tax returns each year, and may require periodic accountings; and (d) the survivor may lose the opportunity to secure a reverse mortgage (and, perhaps, even a conventional mortgage) using the home as collateral: If one-half of the home has been allocated to an irrevocable Exemption Sub-trust, most lenders will not write a reverse mortgage on the home, and many conventional lenders will likewise not lend.

Still another surprise may be that the allocation of a portion of the home to such an Exemption Trust may actually impair long-term care planning where the prospect of a Medi-Cal (California Medicaid) subsidy is desired: (a) the survivor may now be prevented from making a lifetime gift of the home to qualified transferees, a strategy sometimes helpful in order to avoid a later Medi-Cal "payback" claim (but note that such lifetime gifting should only be considered upon the advice and supervision of a knowledgeable Elder Law attorney, as there are tax and other issues that must also be considered), and/or (b) if the survivor later relocates to a nursing home, the successor trustee of a such an Exemption Trust may possiblythen be under a duty to sell the residence to pay for care, thus undermining entitlement to a state Medi-Cal subsidy to help defray these costs.Usually, clients only discover the problems with mandatory sub-trust funding after the death of the first spouse, when it may be too late to modify the trust to address these concerns.

Further, in some situations, there could be an even worse surprise: If one spouse has a substantial amount of separate property, a standard sub-trust allocation devised under the old law could result in a lopsided allocation of assets on the first death, and, possibly, even the partial disinheritance of the surviving spouse.

Consider the following example:assume a second marriage situation, where Husband brings to the marriage $2 million of separate property, Wife has only $50,000 of separate property, and each have children from prior relationships. The couple agrees to keep their assets separate. They establish a Revocable Trust in 2001 when the exemption was $675,000 and use standard "trust split" language to guide the allocations upon the first death. When they created that trust, they both thought the first death would result in an allocation of only $675,000 to the Exemption Trust, and the balance to the Survivor's Trust. However, assume that Husband dies first in the year 2006, when the Exemption will have increased to $2,000,000. Under this scenario, their older trust could result in the allocation of their assets upon Husband's death as follows: $2 million to the Exemption Trust, and only $50,000 to the Survivor's Trust. Because of the change in the law, Husband's entire separate property might thus be directed into the Exemption Trust, where the Survivor's access would likely be restricted and monitored closely by Husband's children, who would usually stand to receive the remainder in that sub-trust upon the death of the surviving spouse, i.e., their step-mother.

Recommendation: married couples who created Revocable Living Trusts prior to 2001, and many created afterward -- especially if created by non-attorneys or by so-called "trust mills" (organizations marketing living trusts at discounted prices and typically prepared in standard formats with little regard for the clients' individual circumstances) would be well advised to have their trusts reviewed by a competent professional, so that the mandatory sub-trust funding instructions can, where appropriate, be modified to avoid unwelcome future surprises.

Gene L. Osofsky, Esq., is a member of ElderLawAnswers' network of qualified elder law attorneys, with offices in Hayward and Pleasanton, California. Visit Attorney Osofsky's home page by clicking here.