For married couples, what happens to your trust property at the death of the first spouse depends on the estate plan that you chose to implement. In this multi-part series, we will review the different administrative paths that property takes, based on the type of trust and the circumstances. In Part I, we explore what occurs at the death of the first spouse when there is a joint living trust in place for married couples.
Generally, trust property passes for the benefit of the surviving spouse in one of three ways:
1. To an irrevocable estate tax planning credit shelter trust, typically called the Family Trust, by formula;
2. To the surviving spouse in their own revocable trust, unless the deceased spouse’s property passes to the irrevocable Family Trust, by disclaimer; or
3. To the surviving spouse in their own revocable trust.
Client estate planning needs can vary greatly. Generally, for joint trust planning, our estate plans provide that on the death of the first spouse, there is a mechanism to protect assets for bloodline or estate tax purposes or, as an alternative, streamlined planning simply provides the surviving spouse with probate avoidance by directing property to a single revocable trust for the surviving spouse. After the provision for the distribution of personal effects and specific bequests, the trust outlines what happens to the remaining trust property at the death of the first spouse. Each of three scenarios are discussed below.
Fractional Funding Formula
A fractional funding formula essentially provides that up to the estate tax exemption, the deceased spouse’s property, as well as one-half of the joint community property, will pass to an irrevocable Family Trust. The remaining balance of the deceased spouse’s property is then held for the surviving spouse’s benefit in some form of Marital Trust. The irrevocable Family Trust is a powerful estate tax planning tool because the property held in this trust uses the first spouse’s estate tax exemption and allows for the property to pass to the denoted beneficiaries at the surviving spouse’s death, free of estate and generation skipping transfer tax.
Before transferring assets into the Family Trust, those assets must be valued. This means that on the death of the first spouse, you will need to work with our office and your accountant to ensure proper valuations are secured for your assets in a timely fashion. For clients with a taxable estate, i.e. net worth in excess of the current estate tax exemption amount of $12.06 million with a sunset in 2026 to $5 million indexed to inflation, funding the Family Trust by formula is worth considering. This irrevocable trust is its own separate legal entity and requires the filing of a separate 1041 tax return for income earned by the trust. This plan is also often used by couples with blended families who want to assure that the assets in the Family Trust pass for the surviving spouse’s enjoyment and then down to denoted children on the death of the surviving spouse.
The use of a disclaimer-based estate plan is an alternative option, whereby the trust assets pass to the surviving spouse, unless the surviving spouse directs that some or all of those assets pass to the Family Trust by “disclaiming” them. The advantage of a disclaimer is that it gives the surviving spouse (or their agent in the event of incapacity) the ability to assess the estate tax threshold at the death of the first spouse before deciding whether to lock the deceased spouse’s assets into the irrevocable Family Trust. However, because the Family Trust is irrevocable, there is no additional adjustment in basis on the death of the surviving spouse. Should there be substantial appreciation, and the estate is under the estate tax exemption amount, clients would likely prefer their heirs to receive a full step up in basis at the death of the second spouse.
While it is extremely difficult to predict what Congress may do with the estate tax, generally clients in the $5 million to $12 million range tend to prefer the “wait and see” flexibility of a disclaimer-based plan. Unfortunately, a disclaimer must be exercised within nine months of the death of the first spouse, and this deadline cannot be missed. Because this deadline can approach quickly while the surviving spouse is adjusting to the loss of their partner, it may be missed if the surviving spouse fails to contact their attorney soon after the death of the first spouse. The good news is that the surviving spouse has the additional flexibility of a portability election, which I wrote about in our May 2021 newsletter.
Survivor’s Trust for Probate Avoidance
With a revocable Survivor’s Trust, by operation of the trust or by not exercising a disclaimer, the surviving spouse maintains complete control of the trust assets. While a valuation of the assets is not required in order to fund the Survivor’s Trust, valuation does properly establish the basis of any appreciated holdings such as land, business interests, etc. for capital gains tax purposes. If the Survivor’s Trust is the only trust created on the death of the first spouse, the surviving spouse is also not required to retitle the property into the Survivor’s Trust. However, we recommend that the retitling occur to help ensure there is no confusion when dealing with financial institutions, and to ensure that the surviving spouse’s social security number is the sole identifying taxpayer number for any trust accounts.