The use of a joint revocable living trust as the primary estate planning instrument can be appropriate for certain married couples whose assets are uncomplicated and whose combined estates are not subject to the estate tax. A joint living trust can, however, result in significant gift and estate tax problems in certain estates for which tax planning is required.
The application of the trust provisions after the death of the first spouse and depends upon whether the value of the trust’s assets is less than or exceeds the amount protected from federal estate tax by the applicable exclusion amount. If the value of the trust property does not exceed the applicable exclusion amount, the revocable trust continues for the benefit of the surviving spouse and, at the survivor’s death, is usually distributed outright to the couple’s family members. The “applicable exclusion amount” is the amount of assets that are exempt from gift and estate tax for each individual. Currently, this amount is $5,000,000, but is scheduled to revert to $1,000,000 in 2013.
If, however, the trust’s assets exceed the amount of the applicable exclusion amount, the trust principal generally is divided at the death of the first spouse into a credit shelter trust (Residuary Trust) and a trust for the surviving spouse (Marital Trust) which qualifies for the marital deduction. At the death of the surviving spouse, the assets in both trusts are distributed to the family members.
The joint revocable living trust should be revocable and subject to amendment by either spouse or both spouses acting together during the joint lifetimes of the spouses. If the trust is revoked, its assets will be distributed to the spouses as they direct. After the death of the first spouse, the trust should remain revocable by the survivor except that any credit shelter trust must be irrevocable to prevent its inclusion in the surviving spouse’s estate and thereby not utilizing the applicable exclusion amount of the first spouse.
Who should consider using a joint revocable lifetime trust?
Joint revocable living trusts can offer some of the same estate planning benefits as do individual revocable living trusts. These benefits include avoidance of the probate process, more privacy, and management of assets in the event of a spouse’s incapacity.
Married couples whose total assets do not exceed the applicable exclusion amount (and who therefore do not need marital deduction/credit shelter estate tax planning to save estate tax at the death of the surviving spouse) may find a single trust convenient and emotionally comfortable. This is particularly true for couples in community property states or those who by deliberate choice own most of their assets as joint tenants with right of survivorship.
However, if the assets owned by both spouses exceed the amount of one applicable exclusion amount, the terms and/or administration of a joint revocable living trust can cause the loss of the credit shelter, failure to qualify for the gift or estate tax-marital deduction, and income tax basis difficulties.
Dangers of joint revocable living trusts.
There are a number of significant tax problems presented by the terms and actual administration of joint revocable living trusts. Many of these potential pitfalls have not yet received IRS attention, so there are not many definitive cases or rulings to provide guidelines. Estate planners who recommend using these trusts for spouses who have assets subject to federal gift and estate tax cannot guarantee to their clients that the intended tax results will in fact be achieved.
Examples of such tax problems include the following:
• Transfers of assets to the trust may be taxable gifts which may not qualify for the gift tax marital deduction.
• If the trust, or a portion of the trust, becomes irrevocable at the death of the first spouse, the surviving spouse may be considered to have made a taxable gift to the remainder beneficiaries of the irrevocable trust.
• At the death of the first spouse, it is unclear whether one-half the value of the trust is included in his estate or the entire trust is included.
• If assets contributed to the trust by each spouse are commingled in a joint trust, it may not be possible to keep what is intended to be a credit shelter trust from being included in the surviving spouse’s estate.
Funding of joint revocable living trust may give rise
to immediate taxable gifts.
To the extent that property contributed to a joint trust by the spouses is unequal in value, a taxable gift may be considered to have occurred. Even if the value of the property contributed by each spouse is equal, the spouse with the shorter life expectancy may be considered to have made a gift to the spouse with the longer life expectancy because the actuarial value of the second spouse’s interest in the trust is larger.
The spouses’ retained right to revoke the trust does not necessarily make a gift incomplete because a donor is not considered to have retained a right to revoke if that right is exercisable jointly with, or only with the consent of, a person who has a substantial adverse interest. In other words, someone who has an economic interest in not agreeing to revoke the trust.
Further, if a gift is considered to have been made by one spouse to the other on the creation and funding of a joint revocable living trust, that gift will not qualify for the gift tax marital deduction because (1) the interest is terminable because the donor-spouse will receive an interest in the property if he or she survives the donee-spouse, and (2) the interest does not qualify for the marital deduction election because under the terms of the trust the donee-spouse is not entitled to receive all the income from the trust and the trustees are authorized to distribute trust principal to the donor-spouse during the donee-spouse’s lifetime.
To avoid the immediate gift on funding the joint trust problem, the trust provisions can give each spouse the power to withdraw from the trust any property which he or she contributed to the trust, or property into which the original contribution has been converted, without the consent of the other spouse. This power should prevent the completion of potential gifts. Careful records of contributions and what new investments were made with the proceeds of sale of any of the original trust property must be maintained for this unlimited withdrawal power to succeed in rendering a potential gift incomplete.
Another way to avoid any chance that a complete gift occurred on funding the trust would be to give each spouse the right to revoke the trust without the consent of the other spouse. This solution may cause problems if the marriage falters after the joint revocable living trust has been created and funded.
Death of first spouse may result in taxable gift by surviving spouse.
If a joint revocable living trust provides that on the death of the first spouse a portion or all of the trust becomes irrevocable, the surviving spouse could be considered to have made a taxable gift at that time to the beneficiaries of the irrevocable trust. The IRS has ruled that where spouses transferred property to a joint revocable trust and retained life income interests, with remainder to charity, the gift to the charity was complete at the death of the first spouse when the trust became irrevocable. This issue has also been the subject of cases and rulings, some finding a gift to have been made, others finding no gift, involving joint, mutual or contractual wills.
There are several ways to prevent a completed gift from being made when the trust becomes irrevocable. One way is to provide the surviving spouse with a power to invade the trust after the first spouse’s death that is not limited by an ascertainable standard. Another is to provide in the trust that the surviving spouse has a power to appoint the principal of the now irrevocable trust at her death. This power would make any potential gift by the surviving spouse incomplete.
How much of trust is included in estate of first dying spouse?
The question of what part of the trust assets is included in the estate of the first spouse to die is important for two primary reasons: (1) the surviving spouse’s interest in the trust may not qualify for the marital deduction; and, (2) determining whether the trust assets will receive a stepped-up basis at the first spouse’s death is partially dependent upon inclusion in the decedent spouse’s gross estate.
There are two different approaches the IRS can take in determining how much of the trust is includable in the estate of the first spouse to die. It can treat a joint trust as similar to a qualified joint interest in which case only one-half the value of the trust would be included in the estate of the first spouse to die. The second alternative assumes the trust assets were commingled during its administration so that it is not possible to trace which assets had originally been contributed by the surviving spouse, in such case, the IRS would include the entire value of the trust in the estate of the first spouse to die. Since all of these approaches are reasonable, the IRS will probably assert the one most favorable to itself under the facts of each trust. Thus, if the trust provisions would disqualify the surviving spouse’s interest for the marital deduction, the IRS might try to include the entire value of the trust property in the estate of the first dying spouse.
One way to insure that the entire trust will be included in the estate of the first spouse to die is for the trust to give the first spouse to die a general testamentary power of appointment over the entire trust. However, even if the entire trust is included in the first spouse’s estate, a basis step up for all the trust assets is not assured.
If a joint revocable living trust is used by spouses whose assets exceed the applicable exclusion amount, the trust should provide that, at the death of the first spouse, the joint revocable trust will be divided by placing the protected amount into a trust for the benefit of the surviving spouse (and descendants, if desired). The marital deduction would not be claimed for this trust in the first dying spouse’s estate and would therefore not be included in the estate of the surviving spouse at his or her death.
The credit shelter trust must be funded with property which was originally contributed to the trust by the decedent spouse if this tax-saving plan is to succeed. If the joint trust assets are not carefully segregated into “his” and “her” contributions during the administration of the trust, the value of the credit shelter trust may be includable in the surviving spouse’s estate at her death on the ground that its assets were originally transferred to the trust by the surviving spouse who then retained a life income interest in the transferred property and a power to revoke the transfer, both of which would require inclusion of the credit shelter trust in her estate, thereby defeating the attempt to save estate tax. If the trust cannot prove that the assets in the credit shelter trust originally came from the decedent spouse, the trust will be included in the survivor’s estate and the tax-saving opportunity will be lost.
As you can see, joint revocable trusts can be useful estate planning instruments under the right circumstances. However, many pitfalls exist in their use. I generally advocate the use of separate trusts for each spouse, and while this estate planning technique may be more costly to a client, separate trusts provide greater protection and certainty in future administration.