Some Trust agreements require the establishment of an Exemption Sub-Trust. This was very common in Trust agreements prior to the dramatic increase in the equivalent exemption for federal estate tax purposes. The principal advantage of an Exemption Sub-Trust that if it is correctly administered during the life of the surviving spouse, at the time of the death of the surviving spouse all of the assets of the Exemption Sub-Trust pass to the beneficiaries federal estate-tax free. This is true even though all of the income (and principal if need be pursuant to an ascertainable standard such as for health, education, maintenance and support) from the Exemption Sub-Trust is used for the benefit of the surviving spouse during his or her lifetime.
When the first spouse dies, the Successor Trustees must determine what Trust assets should be used to fund the Exemption Sub-Trust. This is a very important determination. In light of the fact that the Exemption Sub-Trust assets remaining at the time of the death of surviving spouse will not be subject to federal estate tax regardless of value, in the past the general rule was that assets with high appreciation potential should be used to fund the Exemption Sub-Trust. In other words, the appreciation potential of an asset was the primary factor. This was to avoid federal estate tax when the surviving spouse die, which federal estate tax is due 9 months after the date of death calculated at a 40% tax rate.
However, the equivalent exemption for federal estate tax purposes for deaths occurring in 2014 is $5,340,000.00. The equivalent exemption is indexed for inflation, so it will continue to increase each year in the future. With the large equivalent exemption now in effect and to continue to increase in the future, another primary consideration in funding an Exemption Sub-Trust is the income tax basis of an asset. Assets in the Exemption Sub-Trust have an income tax basis equal to the fair market value on the date of death of the first spouse to die, and there is no “step up in basis” to the value of the asset on the date of death of the surviving spouse. Accordingly, an asset in the Exemption Sub-Trust that has significantly increased in value since the death of the first spouse will, upon sale, have significant taxable gain for income tax purposes. Therefore, when funding the Exemption Sub-Trust, if it appears that there is very little likelihood of any federal estate tax upon the death of the surviving spouse because the surviving spouse’s taxable estate will be less than the projected equivalent exemption, it is prudent not to fund the Exemption Sub-Trust with assets with high appreciation potential assets but leave them in the taxable estate of the surviving spouse. That way when the surviving spouse dies, those assets will receive a step up in basis equal to the fair market value as of the date of death of the surviving spouse. A sale of such asset shortly after the death of the surviving spouse in all likelihood will trigger very little, if any, taxable gain for income tax purposes plus there is no federal estate tax. Accordingly, the beneficiaries have the best of tax worlds, no federal estate tax and a step up in basis for income tax purposes.
At the law office of JEFFREY BURR, we have many years of experience assisting and advising corporate and individual Successor Trustees in the administration of a Trust after the death of a Trustor, including the funding of Exemption and other sub-trusts.