There is a widespread misunderstanding that if you and your spouse had set up a living trust, nothing needs to be done when the first spouse passes away except remove the deceased spouse’s name from bank accounts and real estate deeds. If you were under this impression, you may be leaving a big headache for your heirs and subjecting half of your estate to 35 or 55 percent inheritance tax, unnecessarily.
Most trust documents in California set up for married couples have a traditional “A-B” trust formula. Due to community property laws, typically half the assets belong to each spouse no matter who earned them or whose name is on the account or deed. Assuming the husband passes away first, the wife’s half goes to the A trust for her to do as she pleases, and she reports all income related to these assets on her personal 1040/540 tax returns. The husband’s half goes to the B trust. The husband typically gives his wife the right to use the income generated by the assets in his B trust, and if she does not have enough income from her other assets, she can dip into its principal for her health, education, or maintenance.
The B trust is special because the wife generally has limited control over where those assets go when she passes away. The husband typically determines this in the trust document – after all, it was his half. As a result of her limited control, she is not considered the owner of the B Trust assets and they are not included in her taxable estate when she passes away! In 2013, the estate tax exemption reverted back to $1 million; in California, that might be the value of the family home. In order to get this special tax-exempt treatment, the B trust needs to be “funded” (assets properly divided and retitled to new accounts), and you have to file 1041/541 tax returns for it each year thereafter.
The other significant reason to properly set up the B trust and file returns is “remainder beneficiaries.” These are the people or organizations the husband said would receive the remaining assets in the B trust upon the wife’s passing. Any of these beneficiaries could sue her if she does not segregate the assets and properly follow the terms of the B trust. This is often important if there are children from two marriages, or the deceased spouse wanted to make sure mom did not remarry and give all the money to the new spouse instead of his own children.
The “A/B Trust” is very common Estate Planning technique for married couples. The ideas behind the A/B Trust are to preserve the Estate Tax Exemption of the first spouse to die and to retain a degree of control over the deceased spouse’s share of the estate, protecting the deceased spouse’s beneficiaries from the whims of the surviving spouse. Upon the death of the first spouse, the trust sub-divides into an “A Trust” (also known as a “Survivor’s Trust”) and a “B Trust” (also known as an “Exemption Trust,” a “Bypass Trust,” or a “Family Trust”).
Many surviving spouses who have A/B Trusts either do not realize that upon the death of the first spouse they need to physically split the assets between the A and B Trusts or consciously neglect to split the assets because they feel it’s unnecessary, expensive, or time consuming. Occasionally, a surviving spouse with an A/B Trust will realize years after the death of the first spouse that the A/B split was never completed. Alternatively, the surviving children of a deceased couple who had an A/B Trust where no A/B split was completed upon the death of the first spouse realize the estate was never settled. In both cases, the A/B split should have been done upon the death of the first spouse and the task at hand is to figure out how to handle the situation.
The question becomes whether the assets should be split between the A and B Trusts now, correcting the mistake of neglecting to split the assets upon the first spouse’s death (known as “stale trust funding”), or whether the A/B provisions of the trust can be ignored.
Many people upon first blush will want to ignore the A/B provisions of the trust, believing that trying to correct a mistake made many years ago will undoubtedly create additional legal fees, accounting and tax preparation fees, time, effort, and complications. It is much easier to ignore these problems. However, there are many legal and tax issues that must be carefully considered before deciding to ignore what can be a significant problem.
First, the tax purpose of the A/B split is to preserve the first spouse’s Estate Tax Exemption. If the estate is larger than one spouse’s Estate Tax Exemption, by not performing a stale A/B split, you will be forgoing perhaps hundreds of thousands of dollars in Estate Tax savings.
Second, the beneficiaries of the B Trust might be different than the beneficiaries of the A Trust. If you ignore the A/B split, are you disenfranchising the B Trust beneficiaries?
Third, the Trustee has a fiduciary duty to carry out the terms of the trust and is thus legally required to perform the A/B split if that is what the trust dictates. The Trustee could face serious legal consequences by ignoring the law.
Fourth, the trustee could be held liable for tax returns that were not properly filed.
Normally, an administrative trust tax return is filed for any income generated by the decedent’s assets between the date of death and the date the A and B sub-trusts are funded. After that point, the A trust income gets reported on the surviving spouse’s 1040, and the B trust income is reported on a form 1041 tax return each year going forward.
What happens when the funding is not done for years? Most people in these situations continue to report all the income on their 1040s after their spouse passed away, as if nothing had happened. This is incorrect.
The question is: do you have to go back and file tax returns for the B trust for all those years? The IRS generally takes the position that since the B trust was never funded, there are no tax returns needed for that trust. Once you fund the trust, then you start filing returns for it, even if years later. However, at the same time, the IRS views the decedent’s share of assets as having belonged to an administrative trust since the date of death – still waiting to be properly distributed. This administrative trust should have had tax returns filed every year. It is further complicated when those assets are used, retitled, sold, and mixed with other assets improperly.
There are generally three different approaches to solving the return filing problem. The first is to go back and file tax returns for the administrative trust dating back to the date of death. This is the safest route, but is probably the most expensive, and may be impossible depending on the records available. You also have the problem of potentially amending all your 1040s that were not properly prepared as a result.
The second approach some practitioners use is to essentially file blank 1041s dating back to the date of death and include a statement with each return that all the income was reported on the surviving spouse’s 1040. The problem with this is that the amount of tax owed, besides being paid on behalf of the wrong taxable entity, is rarely the same. Filing blank 1041s clearly brings the issue front and center to the IRS, but, it could also bring closure to the issue.
The third approach some practitioners take is to not file any administrative trust returns for the past, and just start filing returns for the B trust going forward. This approach has risks because required returns are never filed, and therefore the statute of limitations never begins. The issue could theoretically pop-up at any time in the future without the appearance of being forthright.
Most people that fail to fund and file returns for the B trust, treat all the assets as their own, and report all the income on their personal tax returns. The overall tax is never exactly the same compared to filing 1041s even if income is supposed to go to the surviving spouse. Another problem is that capital gains typically do not go to the surviving spouse and are taxed to the trust (although at similar rates). An auditor could say, “Yes, you paid tax, but the trust did not.”
If you failed to fund your B trust, confront the issue by seeking competent professional advice from a CPA and an attorney so you can determine if you need to do something and what your options are. It is also highly recommended that you include your financial advisor as well so you can obtain a multi-disciplinary solution. If there is a potential impact, it will surely resurface in your estate. If it is not addressed before you pass, it will either get more complicated/expensive to handle or create an irreversible consequence.
It is clear there are many issues to consider in a stale trust administration. If you find yourself in this situation as a surviving spouse or you think you may be the future beneficiary of funds from a stale trust, you should seek qualified professional advice to determine if or to what extent you could be affected, and what your options are. Unfortunately, if there is an issue, it almost always resurfaces upon the death of the second spouse, at which point it gets more expensive to handle, is more likely to cause fighting between beneficiaries, or creates an irreversible financial disaster for the beneficiaries.