Cavitch Familo & Durkin, Co., L.P.A.

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This article has been prepared to explain a strategy that has been designed by the estate planning attorneys at Cavitch, Familo & Durkin Co., L.P.A. It has broad application to all families and reshapes how we approach tax planning for estate plans that use trusts.

Due to the historically high federal estate tax exemption and the repeal of the Ohio estate tax, traditional “AB” trusts planning is now obsolete for the vast majority of taxpayers. Many clients with existing AB trust arrangements will find themselves sacrificing valuable income tax planning opportunities for estate tax planning benefits that have little or no economic value given the current estate tax planning landscape. This article will explore these previously un-mined income tax planning opportunities with an eye toward maximizing basis increase for parents (and for future generations of their families), enabling better long-term income tax savings, and maximizing adaptability to future tax law. While this presentation will focus primarily on planning for couples with estates under $10.68 million, the concepts discussed will have a high level of applicability to those with larger estates and single parents as well.1

What’s wrong with traditional AB trust planning? The primary shortcoming of traditional AB trust arrangements is that assets allocated to Trust B (the Credit Shelter Trust) are not eligible for a second cost basis adjustment (stepped up basis) upon the death of the surviving spouse. This is due to the fact that Credit Shelter Trusts are, by design, excludable from the surviving spouse’s taxable estate. Assets that qualify for stepped up basis get a new tax basis equal to their value on the date of death of the owner. Not getting this benefit can be expensive where there is significant growth in the value of trust assets.

Consider the following example: George leaves $2 million in a Credit Shelter Trust for the benefit of his wife, Martha, who outlives George by 10 years. Over that time the income from the Credit Shelter Trust is spent but the fair market value of the principal has doubled to $4 million. Martha has $1 million of her own assets.

Upon Martha’s death, their children will inherit the Credit Shelter Trust assets with only $2 million in basis. Had George’s assets been left to Martha in a manner that would make them includible in her taxable estate however, not only would there still be no estate taxes owed2, but the children would have inherited those assets with $4 million in basis, potentially saving them perhaps $676,000 or more.3

How do we make assets includible in a surviving spouse’s taxable estate in order to obtain the second cost basis adjustment? The simplest methods to make assets includible in a surviving spouse’s taxable estate involve the use of outright bequests and Marital Deduction Trusts. These methods, however, have some serious drawbacks and limitations.

Consider the following example: George leaves his $2 million in a Marital Deduction Trust (the “A” in an AB trust arrangement) for Martha’s benefit. The value of those assets once again doubles to $4 million between George and Martha’s deaths. Due to Congressional action during those intervening years, however, the federal estate tax exemption is lowered to $1 million.4

Because the Marital Deduction Trust assets are includible in Martha’s taxable estate, the children inherit George’s assets with $4 million in basis but they now owe $1.8 million in federal estate taxes.5 If George’s assets were left for Martha in a Credit Shelter Trust instead; the children have only received those assets with a cost basis of $2 million but their estate tax liability would have been $0. This would have saved the children $1.2 million.6 The same result would occur if George’s assets had been left outright to Martha.

Consider another example: Instead of increasing in value over the years between his death and Martha’s, George’s assets decrease in value to $1 million. Because the assets are includible in Martha’s taxable estate (either because they were left to her outright or in a Marital Deduction Trust), the children will lose basis and inherit George’s assets with $1 million of cost basis. This will result in additional capital gains taxes if the assets rebound in value during the children’s lifetimes. If the value of the assets does not rebound (or if they are sold before they have a chance to), this will result in the loss of substantial capital losses that could have otherwise been used to offset current or future gains in asset value.

How do we mitigate these risks when making assets includible in a surviving spouse’s taxable estate? We believe that the proper way to mitigate the various estate and income tax risks described in the preceding section is to retain as many assets as possible up to the available federal estate tax credit in the first spouse to die’s Credit Shelter Trust, but engineer that Trust to allow for certain assets to be includible in the surviving spouse’s taxable estate via the inclusion of a carefully crafted testamentary general power of appointment exercisable by the surviving spouse.

This power is the right of a beneficiary of a trust to designate without limitation in her (or his) Last Will and Testament to whom assets in the trust are to be given on her death.7 The mere right to exercise this power causes the property subject to the power, in this instance the trust property held for the beneficiary, to be included in his estate for purposes of calculating federal estate taxes. Because it is treated as being part of the taxable estate, it qualifies for stepped up basis treatment. It is not necessary for the power holder, i.e. the beneficiary, to actually exercise the power. In fact, in most cases, the power will not be exercised.

We call this super-charged Credit Shelter Trust our “Optimal Benefits Trust.” Here is a brief summary of how it works:

  1. We only want assets to be includible in the surviving spouse’s taxable estate if doing so will not create (or increase) a federal estate tax Therefore, the surviving spouse’s general testamentary power of appointment only applies to so many of the Credit Shelter Trust assets as can be included in their taxable estate without creating or increasing federal estate taxes.

For example: In our prior examples George’s Credit Shelter Trust contains $4 million of assets (as of Martha’s date of death) and Martha has $1 million of her own assets. If the federal estate tax exemption on Martha’s date of death is $5 million, all of the Credit Shelter Trust assets would be subject to the power of appointment.   If however the federal estate tax exemption is only $3.5 million, then only $2.5 million worth of Credit Shelter Trust assets would be subject to that power.

  1. We only want assets with date of death values higher than cost basis to be includible in the surviving spouse’s taxable estate; in other words, we only want a “step up,” not a “step ” In order to so, our power of appointment is further limited to only include such assets.

For example: Assume that of George’s Credit Shelter Trust assets, only half of them have a date of death value higher than cost basis. Because the power of appointment is limited to only allow for these types of assets to become includible in Martha’s taxable estate, the children will inherit them at their adjusted cost basis. The other half of the assets (those with a date of death value lower than cost basis) will be excluded from Martha’s taxable estate and, accordingly, will be inherited by the children at that higher cost basis.

Can we replicate this type of trust arrangement for successive generations of the family? If George and Martha’s trusts provide that their children’s inheritances are to be retained in trust for their lifetime benefit (i.e., “dynasty” trust planning), then very similar general testamentary powers of appointment can be incorporated into those trusts to provide for an optimal cost basis adjustment upon the children’s deaths. In fact, we believe that this type of multi-generational planning scenario is where an even greater benefit can be derived through use of our Optimal Benefit Trust, mainly due to the fact that greater assets gains are typically realized in the intervening years between a parent’s death and the death of a child than between two spouses. This is because the time period from the death of a parent to the death of a child is usually much longer than the time period between the deaths of spouses.
Other Features of the Optimal Benefits Trust 

The Optimal Benefits Trust concept also emphasizes long term asset protection planning for successive generations of a family. Family money is protected in case of a beneficiary’s divorce, financial problems, bad business decisions or bad driving decisions. Creditors of a beneficiary of an Optimal Benefits Trust cannot reach the trust assets while distributions can still be made to or for the benefit of the beneficiary.

Usually, this trust will incorporate dynasty provisions with wealth transfer to successive generations that is exempt from federal and state estate taxes as well as to avoiding successive probate of family property. Privacy is ensured. Flexibility is preserved for following generations through judicious use of powers of appointment.

Taxation of trust income is managed by having trusts for beneficiaries treated as “beneficiary defective trusts.” This means that the beneficiary is treated as the owner of the trust for income tax purposes whether or not income of the trust is distributed to him or her. This is to avoid the compression of income tax rates on trusts where the highest tax rate (39.6%) is reached at only $12,150. Married couples filing jointly reach the top rate only on income above $450,000.

For the past several years estate planners have focused on estate tax planning for their clients. This is understandable considering the modest $338,333 Ohio estate tax exemption and the ever-changing federal exemption. With the repeal of the Ohio estate tax and the narrow applicability of the federal estate tax to Americans, we have come to realize that estate tax planning benefits were often obtained at the cost of losing income tax planning ones. This was acceptable when there were estate tax benefits but no longer acceptable in the current tax environment. Because pre-existing planning arrangements’ often contain estate tax provisions that no longer provide any value to the individuals that established them, we believe that it is necessary to shift our planning and strategic thinking toward those previously lost income tax opportunities.

As to our clients who are residents of Pennsylvania, this strategy will also work notwithstanding the Pennsylvania Inheritance Tax. This is because Pennsylvania does not include as an asset of the deceased’s taxable estate property that is subject to a testamentary power of appointment, which is the crucial component of the tax strategy.

We believe that it is our responsibility as trusted family advisors to make our clients aware of the un-mined planning opportunities that presently exist for themselves and their families. We also feel that financial advisors and accountants need to discuss this strategy with clients so that they are aware of the available benefits.


1 For 2014, the federal estate tax credit is $5,340,000 per taxpayer with scheduled annual increases to offset inflation. Thus, a couple has available $10,680,000 in federal estate tax credits.

2 The addition of the $4 million of assets from George to Martha’s own $1 million would still leave her with a taxable estate less than the current federal estate tax exemption amount.

3Assumes $2 million of taxable gains times a hypothetical 33.80% combined federal (23.8%), state (net 6.2%) long term capital gains tax rate and Net Investment Income Tax (3.8%).

4 This is not entirely hypothetical as there is at least one proposed bill in Congress proposing this and the Obama administration has consistently proposed reducing the estate tax credit to $3,500,000.

5[(George’s $4 million + Martha’s $1 million) – Martha’s $1 million exemption] times hypothetical 45% federal estate tax rate.

6 $1.8 million estate tax liability minus $600,000 in additional capital gains taxes owed.

7 Compare this to a limited power of appointment where property subject to the power can be given to anyone except the power holder, his or her estate or his or her creditors. A limited power is used where we want to give a trust beneficiary the right to appoint property but not have it includible in his estate for federal estate tax purposes.