How Increased Estate Tax Exemptions Affect Existing Trusts

SEPTEMBER 29, 2014 VOLUME 21 NUMBER 35

A lot has changed in American estate planning in the last decade (as you may have already heard). Estate tax thresholds have increased to (as of 2014) $5.34 million. On top of that figure, there is a relatively new concept of “portability” of the estate tax exemption, so that married couples can (more or less) double that exemption amount in most cases. Meanwhile, Arizona has eliminated its estate and gift tax regimens altogether.

It goes without saying, but we can’t avoid saying it: if you haven’t updated your estate plan in the past decade, you should contact your attorney right away about getting that process started. You probably can get by with a simpler estate plan than you needed before, and you can probably make most or all of your decisions on the basis of what you’d like to do with your money, rather than the tax consequences.

Meanwhile, we see a lot of estate plans that have not been updated. Some of those belong to people who have died with their aging wills and trusts in place. We also see a fair number of trusts for people who died years ago, and for whom estate tax liabilities turned out to be unimportant. Is there anything that can be shed to fix tax-driven complications that are no longer needed?

Yes, as it turns out. We do have a couple caveats that need to be mentioned as we open this discussion, though:

1. We are writing about Arizona tax and estate law, not other states’. If you live in another state, or if your trust is set up in another state, you probably ought to speak with someone familiar with that state’s laws. Keep in mind, though, that the governing law might not be obvious; if your mother wrote a trust in, say, Florida, and died in Tennessee naming a California daughter as trustee, do you know which state’s law applies? Neither do we — the answer is going to be very fact-driven, and so the first question you might want to address with a lawyer is whether you’re even talking to a lawyer in the right state.
2. Even if Arizona law applies, or the principles we describe here are the same for the state governing the trust, be very careful about generalizing the points we raise here. Discuss them with an attorney, and be alert for the possibility that seemingly small changes in facts can yield entirely different answers.

Disclaimers in mind, we can proceed to discuss what has to be done, and what can be done, with tax-driven estate plans that have not been updated to modern tax concerns. Here are a few examples of what we see:

• Mr. and Mrs. Johnson created a joint revocable trust in 1995. It provided that on the first spouse’s death, the trust would be divided into two separate trusts. One is called the “decedent’s” trust, and it consists of the separate property of the first spouse to die, plus that spouse’s one-half interest in community property. Since Mr. and Mrs. Johnson are only worth about $1 million, they probably didn’t need such a two-trust arrangement at all — but Mr. Johnson has now died. Mrs. Johnson doesn’t want to go through the bother of dividing assets and, knowing that the estate tax exemption is now several times their combined net worth, she wonders if she can just skip the two-trust part.
• Mr. and Mrs. Gonzales had a very similar trust. Mrs. Gonzales died in 1999, and Mr. Gonzales actually made the division into two trusts. The “decedent’s” trust is now worth about $1 million, and Mr. Gonzales is tired of paying the annual cost of preparing income tax reports for the trust and providing accounting information to his children (they say they don’t want him to have to do that, anyway). Can he just terminate the decedent’s trust?
• Mr. and Mrs. Lee have a very similar trust. Mr. Lee is very ill, and Mrs. Lee has been handling their trust for the past several years. The Lees are worth about $6 million. Is there anything Mrs. Lee should be doing with their trust? Assuming Mr. Lee dies before Mrs. Lee, is there anything she should watch out for?
• Mr. and Mrs. Jorgensen also created their two-trust arrangement in the late 1990s. A very large part of their estate is in Mr. Jorgensen’s 401(k), which names the trust as beneficiary. Is there anything they ought to be thinking about?

Of course the Johnsons, Gonzales’, and Lees could have made changes to their estate plans if both spouses were alive and able to understand and sign changes in each case. But since that didn’t happen, they may be stuck with their estate plans — unless either there is language in the trust or something in Arizona law allowing changes. The Jorgensens are in a little bit different situation, as the decision to name the trust as beneficiary of Mr. Jorgensen’s 401(k) was probably driven by tax considerations that no longer apply.

Let’s deal with the authority to make changes first. We have a couple suggestions for Mrs. Lee, Mr. Gonzales and Mrs. Johnson:

1. Read the trust. Read it again. It may be hard to parse all the rules, but it will be a productive session. Look for things like the discretion to make distributions of principal, the authority to amend the trust, and any authority the trustee (or the surviving spouse) might have to modify the trust’s terms. Nothing there? Don’t panic. But you can’t just choose to ignore the parts you don’t like.
2. Talk to a lawyer about Arizona’s law on modification of trusts. Ask specifically about three words: modification, reformation and decanting. Arizona law now makes it easy to change trust provisions in some circumstances — but note that you may well have an obligation not to hurt the interests of the remainder beneficiaries (children, step-children or whoever receives property on the death of the surviving spouse). Know that Arizona’s trust law has changed dramatically in the past few years, and so even if you got advice that nothing could be changed a decade ago, the answer today might be different.
3. Check with the remainder beneficiaries. They might even agree with you that modification or termination of the trust might be a good idea. Just to be safe, though, talk with your lawyer first; she (or he) might give you a specific idea to discuss with them, or might want to initiate the discussion herself.

Mr. Jorgensen: get in to your lawyer’s office and discuss beneficiary designations. While naming a trust as beneficiary of a retirement account is not necessarily bad, it is usually dangerous and should only be done when you understand exactly what you are trying to accomplish.

Our takeaway: get good legal advice before you just decide to make changes. But don’t despair, as it might be possible to modify old estate plans, even after death.