Old Trusts and New Consequences - The Unintended Income Tax Consequences of Pre-2013 Trusts


Volume 4 • Issue 2 • February 2014

The Counselor is a monthly newsletter of Hallock & Hallock dedicated to providing useful information on estate planning, business succession planning and charitable planning issues. This month's issue will discuss the issue of tax basis and the unintended consequences of not updating an older trust.  If you are interested in learning more about the ideas and processes discussed in this newsletter please contact us for an initial consultation.

With the advent of the American Taxpayer Relief Act (ATRA) at the beginning of 2013 the tax focus of estate planning shifted away from mainly estate (death) taxes to a greater consideration of the income tax consequences of the plan documents.  ATRA made permanent the $5 million per person estate tax exemption (indexed for inflation) and the ability of the surviving spouse to claim the unused estate tax exemption of the decease spouse (known commonly as portability).  The estate tax exemption for individuals dying in 2014 is $5.34 million.  2013 also brought higher taxes on capital gains (maximum rate now 20.0%) as well as the new health care surtax on Net Investment Income (3.8%).  Thus taxes on capital gains may now be as high as 23.8%.

Unfortunately many older trusts do not include the flexibility necessary to account for the higher exemption amount and higher income tax rates.  This is true for many trusts drafted prior to the change in 2013 and it is especially true for trusts drafted prior to 2001.  Trusts should now generally be drafted to allow the surviving spouse the ability to determine whether the greater concern is income taxes or estate taxes.  While the estate tax rate is considerably higher at 40%, the higher exemption amount makes it much less likely that an estate will be subject to estate taxes.  The problem comes when an estate is not entitled to what is known as the step-up in basis.

Tax Basis Explained

While determining tax basis can get very complicated, the original tax basis of an asset is, generally speaking, its cost.  For example, if you purchase a building for $100,000 and pay $20,000 down and assume a mortgage for the $80,000 balance, your original tax basis is $100,000.  This tax basis may be adjusted over time.  If, for example, you have claimed $30,000 of depreciation on the building your new basis is $70,000.  If you subsequently sell the building for $150,000, your taxable gain is the difference between your adjusted tax basis and the sales price, or $80,000.  If, instead of selling the asset, you give it to someone else during your lifetime, the general rule is that your income tax basis carries over to the recipient.  This is known as carry-over basis.  If they then sell for $150,000 they will likewise have $80,000 of gain.  As indicated above, the tax rate could be as high as 23.8%.

Basis Step-up

If, instead of giving the property away during your life, you give it away at your death another rule applies pursuant to I.R.C. 1014.  Retention of the asset until your death subjects the property to potential estate taxes, but the potential gain or loss on the sale of the property is eliminated and the estate or heirs take the property with a new income tax basis equal to the fair market value of the property on your date of death.  Therefore, if you pass the above property to your heirs at your death and the fair market value is $150,000, the new tax basis is $150,000.  If the beneficiary then sells the property for $150,000 there is no taxable gain - a potentially significant tax savings!

The Outdated Trust Problem

The problem with certain outdated trusts is that they inhibit the ability to receive the step-up in basis at death by mandating the use of the deceased spouse’s estate tax exemption.  While this strategy may work well if there is a taxable estate, in 2014 that means the estate must be in excess of $5.34 million for a single person or $10.68 million for a couple.  This is a far cry from the $600,000 per person exemption that was available when many of these trusts were originally established.  Additionally, the exemption was not portable to the surviving spouse at that time.  The low exemption amount and lack of portability meant mandatory funding provisions in a trust made perfect sense.  This is no longer the case.

Consider the following example.  Husband and Wife set up a trust in 1996 when the estate tax exemption was $600,000 per person.  The trust mandates that upon the death of the first spouse, the assets of that spouse will be allocated into one of two sub-trusts.  One sub-trust, the family share, is funded with the deceased spouse’s assets up to the estate tax exemption amount.  The other is funded with all other assets.  Husband passes way in 2011 and the combined estate is $2 million and is owned equally.  The tax basis of the assets was $1 million.  The estate tax exemption is $5 million, so the Husband’s entire share of the estate goes to the family share.  This share gets a stepped up tax basis to $1 million.  Because the assets are not considered community property the surviving spouse does not get a stepped up basis on her share (if it was community property there would be a step up on the surviving spouse’s share as well).  Therefore, the family share has $1 million in assets and a $1 million basis and the marital share has $1 million in assets with a $500,000 basis (the Wife’s share of the original $1 million basis).  Assume the estate grows equally to $3 million by the time Wife passes away.  The marital share now gets a step-up in basis to $1.5 million, but the family share does not get a second step-up.  This means that there will be a taxable gain of $500,000 on a $3 million sale.  See the diagram below:

Now consider the same scenario, but the couple had updated the trust to include needed flexibility. Instead of mandatory funding of the family share, funding is optional with the surviving spouse. As the estate tax exemption covered the entire estate there was no reason to fund the family share. That means that the entire estate gets a stepped up basis on the death of the surviving spouse - a huge income tax savings!


The importance of keeping your planning up to date can never be overemphasized.  The failure to update your estate planning to include current income tax planning techniques that provide maximum flexibility may result in the payment of unnecessary income taxes.

This Newsletter is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. Nothing herein creates an attorney-client relationship between Hallock & Hallock and the reader.