Funding a By-pass Trust

[mactoolsix]

OK, trusts are not my strong point, and a client came to me with a basic question.

Background:
Clients: MFJ community property State (CA)
Net Worth: about $12 Mil
Primarily long term rental properties all held as community property
Spouse passed away February.
Attorney recommends funding the by-pass trust with the faster appreciating properties.

Client's question is why faster appreciating properties?

My reasoning is that property held in the Survivor Trust will receive step-up in basis upon the survivors death. These slower appreciating properties may, or may not, kick-in some estate tax if the assets exceed the then exemption.
Property in the by-pass trust will not receive a step-up, but when distributed and sold by the beneficiaries, will be taxed as LT capital gain. Even though the gain may be more, the tax rate is substantially less.

Will the by-pass trust property be subject to any tax upon the distribution of the assets? I'm thinking yes, and at estate rates (40%).

Am I missing something in the reasoning to fund the by-pass trust with faster appreciating properties?

Thanks,
Mike

[Roland Slugg]

Mike, if trusts are not one of your strong points, I believe the wisest thing to do would be to tell your client that and defer to the advice of the attorney.

Having said that, you may wish to read up on bypass trusts in general and on funding bypass trusts in particular. I suggest this for general education purposes and in order that you will be able to discuss such trusts and related estate planning matters with this and other clients and their attorneys. If you will enter "Bypass trusts" or "Funding of bypass trusts" into Google, I'm sure you will find many good articles on the subjects.

The estate attorney probably recommended funding the bypass trust with the fastest appreciating assets in order to avoid additional estate tax on those same assets when the second spouse ... the W in your case ... dies. The dicey part, however, is to correctly guess which assets those will be. Real estate recently went through a severe downturn in some areas ... of which California was one of the hardest hit ... and most values have not yet rebounded to their former highs. Many stocks, however, have, so who's to say what the fastest appreciating assets will be over the course of the next 5, 10, 15 or more years?

With the recent addition of the portability provision to the estate tax laws the benefit and appeal of bypass trusts was diminished significantly. With your client's net worth at around $12MM a bypass trust may still be beneficial, although that point may be moot since the bypass trust appears to be a fait accompli.

Regarding your question about the taxation of assets sold by the trust or distributed to its benefiary(ies), the distribution of a trust asset to a bene is, generally, not a taxable event, and the bene's basis in the distributed asset is the same as it was in the hands of the trust. If a trust sells an asset, the gain is figured the same as if sold by an individual, and that gain ... ordinary or capital ... is taxed to the trust (on forms 1041/541). However, since a trust's income reaches the highest tax bracket very quickly, the normal procedure is to make distributions of that income to the benes so it is reportable and taxed on their tax returns, perhaps at lower tax rates.

[mactoolsix]

Roland - thank you for your response.

I'm definitely leaving any advice to the attorney, however when the problem was presented I felt I should know the answer or at least understand the basic reasoning. I have googled funding of by-pass trusts several ways, but there are few articles that actually discuss which assets to place or why. I have also begun taking any and all class and seminars on trusts this year, as our office seems to do several trust returns each year.

As for deciding which property would appreciate more than another, this client has that well in hand. He has held most properties in excess of 10 or 15 years. Some are in San Francisco, some in Silicon Valley and others in Arizona. He has a good idea where each is headed, and has no intention of selling any of them.

I understand that if the B-trust sells an asset, it will be in the hook for any taxes due on the gain from the sale (at the high trust rates).
What if upon the death of the surviving spouse, the beneficiaries want to sell some assets held by the B-trust? Can the actual asset be first distributed, sold by the bene and then the beneficiary would pay any tax due on their 1040 at their tax rates, or must the property first be liquidated (sold by the trust) before it can be distributed?


In an effort to understand this, I have put together a scenario:

The estate is valued at $10,340,000 when the first spouse passes away. $5,340,000 of the estate’s assets is identified as appreciating at 10% @ year, while the balance appreciates at only 3% @ year. Surviving spouse lives another 5 years.

. . . . . . . . . . . . . . . B-Trust 10% . . . . A-Trust 3%
Beginning basis . . . . . 5,340,000 . . . . .5,000,000
Appreciation 5 yrs . . . .3,260,123 . . . . . . 796,370
Total value in 5 yrs . . . 8,600,123 . . . . .5,796,370

Upon final disposition, the B-Trust growth will be subject to long term capital gain taxes – currently 20% or about $650,000 - on the beneficiaries 1040.
The amount in the A-Trust which exceeds the exemption – currently 5,340,000 – is 476,370. The estate tax rate is 40% for anything over the exemption. The estate tax = $190,548. (However, the exemption is set to go up each year).
Total tax upon death of the surviving spouse = $840,548 (650,000+190,548).


Now reverse the assets:
. . . . . . . . . . . . . . . B-Trust 3% . . . . .A-Trust 10%
Beginning basis . . . . .5,000,000 . . . . . . 5,340,000
Appreciation 5 yrs . . . . 796,370 . . . . . . 3,260,123
Total value in 5 yrs . . .5,796,370 . . . . . .8,600,123

B-Trust growth will be subject to long term capital gain taxes – currently 20% or about $159,274.
The amount in the A-Trust which exceeds the exemption – currently 5,340,000 – is 3,260,123. The estate tax rate is 40% for anything over the exemption. The estate tax = $1,304,049.
Total tax upon death of the surviving spouse = $1,463,323 (159,274+1,304,049).

The difference is $622,755.

Thanks for your time!
Mike

I just reread your post - "However, since a trust's income reaches the highest tax bracket very quickly, the normal procedure is to make distributions of that income to the benes so it is reportable and taxed on their tax returns, perhaps at lower tax rates."

If the trust sells the asset, and distributes the proceeds, the income would retain the same character and be tax at the 1040 rates . . !!! Thank you.
Mike

[BOB W]

I'm probably wrong, but an on going trust does not have the option to distribute LTCG to beneficiaries UNLESS it is the final year of the trust...???????

[Burke]

There has been a lot of new thinking by courts on this requirement, (i.e, that capital gains stay in the trust and are not distributed -- or used in the calculation of DNI). Unless specifically stated by the trust document, they are willing to give a lot more attention to the discretion of the trustee in this matter, in order to minimize the taxation and therefore depletion of trust funds for the beneficiary.

[BOB W]

There has been a lot of new thinking by courts on this requirement, (i.e, that capital gains stay in the trust and are not distributed -- or used in the calculation of DNI). Unless specifically stated by the trust document, they are willing to give a lot more attention to the discretion of the trustee in this matter, in order to minimize the taxation and therefore depletion of trust funds for the beneficiary.

So, does one gamble and make the LTCG distribution without filing a final return or what? If it is not written in stone, the results can be a disaster.

[Burke]

A trust has to file a return every year if it has sufficient income, and assuming it has capital gains in that year, it will have such income. Then the distribution is shown on the return. Assuming there are distributions made to the beneficiary.

[BOB W]

A trust has to file a return every year if it has sufficient income, and assuming it has capital gains in that year, it will have such income. Then the distribution is shown on the return.

Sorry, but that was a non answer.

[Burke]

Sorry, but not sure what you are looking for.