A common scenario in estate planning occurs when a Husband and Wife set up a joint living trust. To illustrate, assume the Husband and Wife have $10 million in combined assets, all held in the joint trust. Under the terms of the trust, upon the first spouse’s death, the assets are to be split equally into two sub-trusts. One half of the property will be funded into a sub-trust for the survivor, which the survivor will be able to control, modify, and revoke. The other half of the property will be funded into an irrevocable sub-trust under which the survivor is the sole current beneficiary, but upon the surviving spouse’s death, the balance will pass to the children of the deceased spouse.
It is now 2024, and Husband dies. Current estate and gift tax law provides that the Husband and the Wife each have a $13,610,000 federal estate and gift tax exemption. Wife asks her financial advisors, her accountant, and her insurance agent whether she still needs to fund the $5 million sub-trust (for purposes of this discussion, identified as “Husband’s Trust”). There is arguably no “probate” estate or “taxable” estate, but work still needs to be done with the joint trust. Wife wonders if funding the sub-trust is necessary because the estate and gift tax exemption has risen to $13.61 million. Notwithstanding recent changes in the federal estate and gift tax, there are several reasons why she should still fund Husband’s Trust.
- Ensure Disbursement to Husband’s Named Beneficiaries. Funding Husband’s Trust ensures that upon Wife’s death, the balance of Husband’s Trust passes to Husband’s beneficiaries. If all of the property is retained by Wife, Wife can pass all property to family members, friends, a new boyfriend, a new husband, or charities of her choice. In taking such action, not only would she be disregarding Husband’s wishes, she would be establishing the basis for a fiduciary dispute between herself and her Husband’s beneficiaries.
- Provide Creditor Protection for Wife. If Wife funds Husband’s Trust, the assets designated to that sub-trust are potentially titled in a creditor-protected sub-trust set up for Wife’s benefit. What if Wife faces a catastrophic health care claim or liability from a bad car accident? If these assets pass into a properly drafted Husband’s Trust for her benefit, she is a discretionary beneficiary of Husband’s Trust for her lifetime, but is never considered the owner of such assets. As a result, she maintains the benefit of the assets in Husband’s Trust but none of Wife’s creditors can attack such assets.
- Eliminate Estate Tax. By funding the Husband’s Trust, those assets, plus any appreciation, will be available for Wife’s benefit but will not be in Wife’s taxable estate. Not too many years ago (back in 2012), planners were advising clients that Congress would reduce the estate and gift tax credit to $1 million. Right now, the estate tax exemption is the highest it has been in history, but on December 31, 2025, barring action by Congress, the exemption will revert to $5 million per individual, adjusted for inflation. If the estate and gift tax credit is reduced in the future, any amount that passed into Husband’s Trust, plus any appreciation on that property, will be out of Wife’s taxable estate forever.
- Establish Protection for Children. An element of Husband’s Trust may provide (when drafted properly) that Wife receive full use of the property for her lifetime, but upon her death, the balance will be split into separate shares for each of Husband’s children. These shares may be placed into generation-skipping tax (“GST”) exempt trusts for the children. In that scenario, the children will not only have estate tax protection, but may also achieve generation-skipping tax protection, creditor protection, and spousal protection in the event of divorce.
- State Estate Tax. Wife should be aware that although the federal estate and gift tax exemption is presently $13.61 million, and although Arizona law does not presently have an estate tax, several states have estate or inheritance taxes. Further, most of those states have exemptions considerably lower than $13.61 million. Therefore, depending upon where Wife is living when she dies, she may unwittingly trigger considerable state estate tax at the time of her death if she does not fund Husband’s Trust.
- Tax Considerations. There are also certain estate tax and income tax considerations that accompany the administration of a decedent’s estate, including but not limited to a step-up in income tax basis. These considerations are a material part of the analysis that must be factored in when funding the Husband’s Trust.
- Fulfill Husband’s Testamentary Wishes. While the above points are important reasons to complete the sub-trust funding, the primary reason to fund Husband’s Trust is that both Husband and Wife agreed when they created their Trust to fund Husband’s Trust. In making this agreement, Husband wanted to be assured that his property would pass to his children upon death. He also wanted to protect his share of the property from Wife’s creditors. It was clearly his intent and desire to protect and preserve his share of their property, and to do so through the tools and protections offered by the Husband’s Trust.
Unfortunately, upon the death of a spouse, many surviving spouses choose to do nothing. In the foregoing example, if Wife, as surviving spouse, chooses to do nothing, Wife can open herself up to breach-of-fiduciary claims from Husband’s children. Even if these are also Wife’s children, what happens if Wife remarries and passes everything to a new spouse? Husband’s surviving children then make a claim against Wife’s Estate since she chose to pass everything to her new spouse, rather than to the surviving children as required under the joint trust.
When our clients have a joint trust that requires them to fund a trust under the available exemption amount upon their spouse’s death, we caution them against simply choosing to do nothing. In our example above, rather than do nothing, our advice is that Wife fund and operate Husband’s Trust. As an alternative, if the entire family and Wife agree that she will not fund Husband’s Trust, all family members must enter into an agreement acknowledging their understanding and agreeing to waive any rights to Husband’s Trust and all of the other benefits listed above. Under the terms of that agreement, all family members would need to acknowledge that: i) they are relieving Wife of any fiduciary obligation; ii) all property passes to Wife outright; and iii) no property will be held as provided in Husband’s Trust. Anything less than the execution of a complete agreement to this effect leaves Wife’s estate open to the claims of Husband’s family, and more often than not, results in unnecessary family discord.