Small Adjustments to Estate Plans Can Save Income Tax Without Triggering Estate Tax

Estate Planning  

July 27, 2015

Executive Summary: In light of recent changes in federal tax law, married couples with assets of less than $11 million or so may be able to achieve significant income tax savings with a few minor tweaks to their estate plans.  Many existing estate plans were drafted with an eye toward minimizing estate taxes and were often structured in a way that sacrificed potential future income tax savings in order to achieve those estate tax savings.  However, recent federal tax law changes have eliminated this trade-off for most people.  Now you may be able to reduce capital gains tax exposure for your beneficiaries at no estate tax cost.  If you are married and your estate plan was drafted more than three years ago, you should review your plan to see whether a simple amendment could help save income taxes.

The American Taxpayer Relief Act of 2012 (ATRA) took effect in January 2013 and made “permanent” some significant tax law changes. (The changes are permanent in the sense that they have no scheduled sunset dates.)  Each taxpayer now has a combined gift and estate tax exemption equal to $5 million, indexed for inflation since 2010.  The inflation-adjusted exemption amount is $5,430,000 for 2015.  The same exemption applies for generation-skipping transfer tax purposes. Taxable gifts during lifetime reduce the exemption available to shelter at-death gifts from estate tax, but annual exclusion gifts (currently allowed up to $14,000 per donee) do not count against the exemption.

The impact of these changes is most dramatic for married couples.  Each spouse has his or her own, separate exemption; spouses do not share a single exemption.  Additionally, a surviving spouse may now claim whatever portion of the deceased spouse’s exemption that was not consumed by the deceased spouse, provided an election to claim the unused exemption is made on a timely filed estate tax return for the deceased spouse’s estate.  This transfer of unused exemption between spouses is known as exemption “portability.” Thus, to use the most dramatic example, if the deceased spouse did not consume any of his or her exemption, and the survivor elected portability, the survivor would have $10,860,000 of exemption to apply to his or her own estate!  And this is just the 2015 number.  The exemption amount of the surviving spouse will continue to increase in future years as it is further adjusted for inflation.

Despite these favorable gift and estate tax changes, the tax law continues to allow for an adjustment to the income tax basis of most assets in an estate to their fair market value as of the date of death.  The gain on the sale of an asset equals the net sales price less the income tax basis of the asset.  The basis adjustment to market value in an estate can therefore be important for assets that have appreciated over time.  For example, if a person paid $100,000 for a home worth $500,000 at his death, the recipients of that home at his death receive a “stepped-up” income tax basis of $500,000 and can sell the home for $500,000 without paying any capital gains tax.

Marital Deduction Allows for Second Basis Adjustment on Survivor’s Death

When an asset receives a basis adjustment on the death of the first spouse to die, and that asset is still on hand when the surviving spouse dies, that asset may or may not receive a second basis adjustment on the survivor’s death, depending on how the spouses’ estate plan was structured.  When a spouse leaves property to the other spouse in trust rather than outright, a basis adjustment is generally available for the trust property at the survivor’s death only if the trust (a) qualified for the estate tax marital deduction at the first death and (b) a marital deduction election was made on the deceased spouse’s estate tax return.  Otherwise, the basis of property left in trust is generally locked in based on the value at the first death.  When income tax basis is “frozen” in this manner, a couple’s beneficiaries may be saddled with significant capital gains tax liability when an asset is sold after the survivor’s death, depending primarily on the length of time between the spouses’ deaths and the amount of market appreciation in the estate assets during that time.

Marital Deduction Election Will Now Seldom Have Estate Tax Impact

The marital deduction election causes the marital trust assets to be included in the surviving spouse’s taxable estate.  But in the vast majority of cases, the surviving spouse’s exemption will be large enough to avoid federal estate tax on the survivor’s estate in any event, especially when the survivor has taken advantage of exemption portability.  In order to achieve the benefit of a second basis adjustment on marital trust assets, however, the trust must be structured in a manner that qualifies for the estate tax marital deduction.  This generally requires that the surviving spouse (a) be the only beneficiary during his or her lifetime and (b) be entitled to all trust accounting income at least annually.

Many Existing Trusts and Wills Preclude Marital Deduction

The lifetime distribution provisions in existing estate planning documents (usually living trusts these days) vary according to the goals that were most important to the clients at the time the documents were created.  Most existing trusts were created at a time when the estate tax exemption was much less generous than it is today so that minimizing estate tax was a more important goal than minimizing capital gains tax.  Accordingly, many of those trusts were drafted in a manner designed to keep the deceased spouse’s assets (or community share of joint assets) out of the surviving spouse’s taxable estate and make full use of the deceased spouse’s estate tax exemption to shelter those assets from estate tax at the first death.  Such trusts typically called for the deceased spouse’s estate, up to his or her available exemption amount, to be allocated to a trust for the survivor’s lifetime benefit (variously referred to as a “Bypass Trust,” “Exemption Trust,” or “Credit Shelter Trust”) that was not intended to qualify for the estate tax marital deduction.  The married couple was forced to sacrifice a second income tax basis adjustment as the price of using both spouses’ estate tax exemptions.

Because of the tax law changes noted above, this trade-off is no longer necessary for the vast majority of our clients.  For this reason, we urge you to review your existing marital trust distribution provisions to be sure that they do not needlessly preclude a second adjustment in income tax basis on marital trust assets at the surviving spouse’s death.

Here are a few examples of lifetime distribution provisions that may appear in your Bypass Trust, Exemption Trust, or Credit Shelter Trust, if you included such a trust in your trust instrument or wills:

Example 1: “The trustee shall distribute to the surviving spouse all trust income at least annually and as much principal as he or she needs for health, education, support and maintenance for his or her lifetime.”

Example 2: “The trustee shall distribute as much trust income and principal to the surviving spouse as he or she needs for health, education, support and maintenance for his or her lifetime.”

Example 3: “The trustee shall distribute to the surviving spouse all trust income at least annually and shall distribute to the surviving spouse and to the settlors’ children as much principal as they need for health, education, support and maintenance for their lifetimes.”

The trust in example 1 could qualify for the marital deduction election because it requires the distribution of all trust income at least annually, and only the surviving spouse is the lifetime beneficiary.  The trust in example 2 would not qualify because it does not require those income distributions.  The trust in example 3 would not qualify because the surviving spouse is not the sole lifetime beneficiary.

Those trusts that do not qualify for the marital deduction could be modified to qualify by means of a very simple amendment, in many cases without changing the relative economic position of the surviving spouse and the remainder beneficiaries.

If your living trust (or your will, if you do not have a living trust) allocates the deceased spouse’s entire share to a marital trust that is designed to qualify for the marital deduction – typically referred to as a Qualified Terminable Interest Property (QTIP) Trust – the potential income tax problem described above does not apply, and you do not need to modify your QTIP Trust in order to avoid the problem.

An IRS Revenue Procedure from many years ago states that a marital deduction election will be disregarded where the election was not necessary to avoid estate tax that would otherwise be due at the first death.  If that Revenue Procedure were to be followed in the future, the strategy discussed above would clearly not work.  We are still waiting for IRS to tell us whether that Revenue Procedure will continue to apply.  However, most estate planners believe that this Revenue Procedure (which was intended to benefit taxpayers by negating unintentional or ill-advised marital deductions) will not be problematic and that the estate tax marital deduction will be allowed in any event, even if the estate is not large enough to generate an estate tax.


In summary, if you are a married couple, a minor amendment to the spousal trust distribution provisions in your trust or wills may save your family significant income taxes and do so at no estate tax cost.   If you have a spousal  trust that currently does not qualify for the marital deduction, you should consider such an amendment.  Any such amendment must be made while both spouses are alive and have the capacity to amend documents.  Once one spouse has died, the marital trust provisions become irrevocable and no longer subject to amendment.