CHAPTER 13

Splitting the Living Trust Assets After Your Spouse Dies, Preparing Your Spouse’s Estate Tax Return, and Other Tax Stuff That You Would Rather Just Ignore OR AS MUCH AS YOU WANT TO, DON’T SKIP THIS CHAPTER! TO PREVENT ESTATE TAXES AFTER YOUR DEATH, YOU MUST DEAL WITH ESTATE TAX MATTERS AFTER YOUR SPOUSE’S DEATH

The mere words estate tax may make you run screaming for the hills in boredom. Well, perhaps I should not assume what accounts for your running and screaming. For me, it’s boredom. For you, it may be anger that comes from having to deal with tax stuff after your spouse has died. For others, perhaps it is fear of the prospect of having to tangle with the Internal Revenue Service (IRS) in the estate tax arena, a completely different venue than the normal income tax area with which you have some familiarity.

The estate tax stuff is one of the reasons you established your Living Trust in the first place. Even though there is usually no estate tax due on the death of the deceased spouse, there still may be estate tax stuff that needs to be done so that little or no estate tax will be due when the surviving spouse dies. Put another way: You paid for it. You might as well become familiar with what you paid for.

What Is the Estate Tax?

The estate tax is a federal tax on the after-death transfer of your assets and wealth to your Living Trust beneficiaries and the beneficiaries of your assets outside your Living Trust such as insurance policies, individual retirement accounts (IRAs), “pay over on death” accounts, and so on. The estate tax is sometimes referred to as the “death tax,” which is quite misleading, because it gives one the impression that there is a tax on death. The government does not mandate that you pay taxes as a result of your death. If that were the case, then the government would be constantly reaping profits and be able to retire the insanely high federal deficit, because thousands of people die in the United States every day.

Again, this is a tax on the transfer of assets from the dead to the living. If this transfer took place during your lifetime, the tax imposed on that transfer would be a gift tax. So, if you think you can escape estate taxes by transferring what you own before you die, think again. If you could do that, then everyone would do that, and the IRS would never get its share on the transfer of your money and property. Thus, under current law, the IRS will nail you with a gift tax if you transfer assets worth more than $1 million.

After the death of your spouse, there are two aspects about the estate tax in the context of your Living Trust that you must know. Why? Because tending to these matters now—after the death of your spouse—will save your Living Trust beneficiaries thousands of dollars in estate taxes after your death. In other words, the estate tax training you put in now will pay off after you die.

I can hear your footsteps now as you are running away. As I grab you by the collar to prevent your escape (which causes you to run in place like Snagglepuss in the old Hanna-Barbera cartoons), let me give you some helpful perspective. In my practice, I have to slog through what seems like an interminable amount of estate tax treatises, updates, and periodicals that discuss the latest estate tax concepts and Tax Court cases. They are so dry and monotonous that I actually have to steel myself just to pick them out of my mailbox. But for you, all you have to know is these two concepts that, once implemented, will have the practical effect of saving money for your Living Trust beneficiaries. The two estate tax concepts that you need to know are:

1. Preparing your spouse’s death inventory—the federal estate tax return.

2. Allocating your spouse’s half of the Living Trust assets to a separate subtrust called the exemption trust.

So get back here, and let’s begin!

Preparing Your Spouse’s Death Inventory—the Federal Estate Tax Return

When your spouse dies, you may have to file your deceased spouse’s federal estate tax return. This return is nothing like your income tax return. It’s a completely different animal. Let me put it this way: I could not prepare my own income tax return to save my life, but I have prepared over 350 estate tax returns.

The estate tax return does not report income earned by you and your spouse. Rather, the estate tax return reports what your spouse owned at the time of his or her death. In essence, it is a death inventory—that is, a 40-page document prepared by a Living Trust attorney who is relying on you to provide him or her with the values of all the assets that were owned by your deceased spouse.

In my mind, the death inventory preparation is truly an arduous task that your attorney asks you to do during a particularly emotional time. During the grieving process, you may not feel like doing anything that requires energy and acumen. But now, if you are required to file the estate tax return, you have to make the effort to fish around for information that your attorney needs to file the estate tax return. You have to hire an appraiser to obtain the value of your real estate. You have to contact your brokerage representative to get statements that show the value of the stocks and securities on the exact date of death. You have to go to your bank to get bank statements showing date-of-death balances. You have to make lists of all the personal property in your house—clothes, furniture, jewelry, antiques—and have those items appraised. You have to call your insurance companies to find out the cash values of the policies. You have to get in your car, find parking, and meet with your attorney several times.

As you can see by this exhaustive list, compiling an inventory for your deceased spouse’s estate tax return is a lot of work. Moreover, this list must be compiled relatively quickly. The IRS deadline to file the return is within nine months after the death of your spouse, which is certainly not a lot of time given that you may be emotionally debilitated to the point where you cannot handle dealing with such business matters. Your attorney can obtain a filing extension of six months, but it must be applied for within that nine-month period. However, I can tell you that the 15-month filing deadline will be here (snap of the fingers) like that.

But, as I have indicated, you may not be required to file the estate tax return. There are two situations that require you to file the return. During my discussion of these two situations, please keep in mind that a return may have to be filed even if no estate tax is due!

1. You must file the return if your deceased spouse’s half of all assets—whether or not in the Living Trust—exceed the present “exemption amount.” For purposes of this section of this chapter, this is the maximum amount of assets the IRS says that your deceased spouse is allowed to own without you—the surviving spouse—being obligated to file an estate tax return. Under current law, the exemption amount in 2008 is $2 million. In 2009, the exemption amount increases to $3.5 million. In 2010, there is no exemption amount, because there is, for this one year only, no estate tax at all, so no one will be filing an estate tax return. But in 2011, the estate tax return kicks back in with a reduced exemption amount of $1 million.

2. You must file the return if there is an estate tax due. An estate tax will be due if (1) the assets of your deceased spouse pass to people other than you—the surviving spouse—and (2) the assets of your deceased spouse passing to people other than you—the surviving spouse—exceed the exemption amount.

Why is there no estate tax on the transfer of any assets from your deceased spouse to you, the surviving spouse? Because of an IRS rule called the marital deduction. This means that there is a dollar-for-dollar estate tax deduction for any transfer of assets from a deceased spouse to a surviving spouse. The IRS is not being nice. It is just waiting to impose an estate tax on those assets when you die.

Allocating Your Spouse’s Half of the Living Trust Assets to a Separate Subtrust Called the Exemption Trust

Your Living Trust’s inheritance instructions may provide that on the death of the first spouse, his or her half of the assets in the Living Trust bucket will be allocated to a separate subtrust. For now, let’s call it the “smaller bucket.”

Don’t worry—the smaller bucket is not described in some other document that you signed at the time you established your Living Trust. In your Living Trust, there is a section that details what creates the smaller bucket after the deceased spouse’s death and discusses how it functions.

Basically, this section states three functions of the smaller bucket during your life:

1. You receive the income from the smaller bucket, which you keep, invest, and spend on anything and in any way you desire.

2. You get to spend the principal from the smaller bucket for your health and support, which is usually defined as the amount of assets necessary and reasonable to provide you with a comfortable standard of living.

3. You get to wheel and deal with the smaller bucket assets (buy, sell, trade, refinance, invest, borrow against—whatever) in any way you wish.

With all of your power and control over the assets in the smaller bucket, it appears that you own those assets. That’s what it sounds like to me. However, in a complete betrayal of your confidence in me and my assertions, you are, in fact, not the owner of the assets in the smaller bucket. Yes, you get the income, principal, and managerial power—just like any owner of property. But the real owner is still your deceased spouse.

In other words, your deceased spouse is the owner of the assets in the smaller bucket, and you are merely the authorized user of those assets for the rest of your life.

Let me say this more succinctly. For all practical purposes, you are the owner of the assets in the smaller bucket. But from a legal perspective, your deceased spouse is the owner of those assets.

Why engage in this charade? In one word—taxes. As your Living Trust advisor, I don’t necessarily want you to be considered the owner of the assets in the smaller bucket. If you own them, the IRS will impose an estate tax on them when you die. But if you don’t own those assets, the IRS cannot tax them on your death—because you don’t own them! How’s that for circular reasoning? You cannot be taxed on what you don’t own. In legal parlance, this is called “reducing your taxable estate.”

The Real Name of the Smaller Bucket Is . . .

In your Living Trust, the smaller bucket may be referred to by any one of a number of names. I call it the “exemption trust” because the assets in that subtrust will be exempt from estate tax on your death. Another reason I call it the exemption trust is because what it really does is preserve the exemption amount of your deceased spouse.

Don’t let your eyes glaze over yet. Give me a chance to explain what this means.

I alluded to the exemption amount earlier in this chapter in the context of filing your spouse’s estate tax return. In that section, I defined the exemption amount as the maximum amount of assets the IRS says that your deceased spouse is allowed to own without you—the surviving spouse—being obligated to file an estate tax return. Okay. But now I must give that definition a slightly different bent in order to help you understand the exemption trust for this section dealing with the allocation of your deceased spouse’s half to the exemption trust.

For purposes of this section, the exemption amount is the amount of Living Trust assets your deceased spouse can leave to the children tax-free. The amount is dependent on when your spouse dies. The higher the exemption amount, the more your deceased spouse can leave to your children without the imposition of an estate tax. For example, if your spouse dies in the year that I write this very sentence (2008), the exemption amount is $2 million. If your spouse dies in 2009, the exemption amount is $3.5 million. In 2010, there is no exemption amount because, for the first time in a very long time, there is no estate tax, but for one year only. In 2011, the estate tax is back and the exemption amount is fixed at a permanent $1 million.

When you allocate your deceased spouse’s half of the Living Trust assets to the exemption trust, you are transferring assets that are “painted” with your deceased spouse’s exemption amount. What is the effect? The assets in the exemption trust do not belong to you, and they are not distributed to the children or other Living Trust beneficiaries. Instead, those assets stay in the exemption trust for the rest of your life, providing you with income and principal for your support and health in the event that your half of the Living Trust assets is insufficient to provide for those needs.

When you—the surviving spouse—die, the assets in the exemption trust will pass to the children with no estate tax whatsoever. In effect, the exemption trust has preserved the exemption amount of your deceased spouse while allowing you, the surviving spouse, the ability to use those assets for the rest of your life.

So one more time—with feeling! The exemption trust preserves your deceased spouse’s right to leave his or her half of the Living Trust assets to the children, or other Living Trust beneficiaries, free of estate tax.

Here is another benefit of having assets in the exemption trust. If those assets appreciate, the appreciation will also pass to your children tax-free. For example, after your spouse’s death, you allocate $250,000 of stocks to the exemption trust. You are the greatest investor of money the world has ever seen—Warren Buffett is nothing compared to you. You invest that $250,000 to the point where it is worth $5 billion on your death. Guess what? If the root of the tree is tax-free ($250,000), the fruit of the tree is tax-free ($5 billion). In other words, the children won’t have to pay any taxes on that $5 billion!

The Magic Trick

As your Living Trust advisor, I must say that these are really nifty tricks. The exemption trust will, like magic, prevent your deceased spouse’s share of the Living Trust assets, and its appreciation, from being estate taxed on your death. But, like any magical illusion, there is some effort the magician must make in order for it to work and look so easy.

What a fabulous analogy! You are the magician who must engage in a number of steps in order to achieve the illusion (estate tax avoidance) that is the goal of the trick (the exemption trust). And if you, the magician, do not make the required effort, the trick (estate tax avoidance) will not work, and you will be booed (taxed) by the audience (the IRS). (This is good stuff. I am finally using the writing skills and devices I learned as an English literature major at UCLA.)

So, what is the effort you will have to make for the trick to work? It’s the kind of effort that gives the IRS the distinct impression that the exemption trust is a separate and viable entity. If the trick works, the IRS will say that the exemption trust assets are not owned by you and, thus, are not part of your taxable estate on your death.

If the trick does not work, then the IRS will “pierce the veil of separateness” and will proclaim that you, and not your deceased spouse, are the owner of the exemption trust assets and, therefore, those assets are part of your taxable estate on your death.

As your Living Trust advisor, I am here to tell you how to perform this magic trick. All you have to do is follow seven steps.

1. You will need to file a separate income tax return each year for the exemption trust if the assets in the exemption trust generate income (e.g., investment real estate, brokerage assets, certificates of deposit). The exemption trust, like any corporation or other business entity, for tax purposes is considered a separate person. And like any person, it files its own income tax returns . . . for the rest of its life.

Don’t allow this income tax concept to confuse you about the estate tax training you are receiving. For the most part, and for the purposes of this book, income tax has nothing to do with estate tax.

Also, you may be somewhat confused by my statement that you need to file exemption trust income tax returns because of my previous statement that the exemption trust is tax-free. Don’t be. The exemption trust is tax-free. When you die, the assets in the exemption trust will pass to your Living Trust beneficiaries without any estate tax. But, it’s not quite the free lunch you wanted. During your lifetime, if those exemption trust assets generate income, the IRS still wants to impose an income tax on that income. That is why you will need to file a separate income tax return for the exemption trust and pay income tax.

2. All exemption trust assets must be vested in the name of the exemption trust. This means you have to retitle the bank accounts and brokerage accounts that you allocate to the exemption trust. If you are transferring all or a portion of real estate to the exemption trust, the deed to that property must reflect that new ownership.

3. All income generated by exemption trust assets cannot be allowed to sit in the exemption trust accounts. Rather, the income must be taken out of those accounts and transferred to your accounts. Why? Because even though the exemption trust assets, and their appreciation, are exempt from estate tax on your death, the income from those assets is not so exempt. If the income is allowed to stay in the exemption trust accounts, somebody (your after-death agent) will have to go through tons of statements to re-create a separation of taxable income and nontaxable appreciation. Not a fun prospect. As a result, you have to arrange with your bank or brokerage officer to have all income and dividends from the exemption trust automatically transferred to your accounts.

4. You have to trace exemption trust assets from one form to the next. In other words, you have to keep the exemption trust assets in the name of the exemption trust at all times—no matter what form those assets subsequently take.

For example, say you allocate your deceased spouse’s one-half share of your home to the exemption trust. You sell the home for $300,000 and put the proceeds in the bank. You have to open up two accounts—one for $150,000 in the name of the exemption trust, and the other in your name (or the name of your Living Trust). If you then apply the $150,000 in the exemption trust account toward the purchase of securities, the securities must be purchased in the name of the exemption trust. You can wheel and deal all you want—but you have to maintain the exemption trust status of the new assets.

5. You cannot give away exemption trust assets. Sure, you can wheel and deal with them as often as you want, and you can use them for your health and support (defined as the amount necessary to maintain your comfortable standard of living), but you cannot make gifts of them.

For example, say you meet the person you desire as your next spouse. You are smitten with this person to the extent that, to show your love, you wish to give him or her all the assets you own. Certainly, no one can legally stop you from foolishly giving away your share of the Living Trust assets. But, if your generosity includes dipping into and giving away a portion of the exemption trust assets, the entire tax-free status of the exemption trust is seriously jeopardized. If you give any of them away, the IRS will say that you exercised too much control over those assets and, as a result, will deem you to be the owner of those assets. And if you own them, they will be taxed on your death.

6. You cannot use the exemption trust assets for anything other than your support or health. This is huge. If you are caught using exemption trust assets for any purpose other than your support or health, the IRS will take away the exemption trust’s tax-free status.

What is considered a violation of this standard for invasion of exemption trust principal? Look again at the definition of support—the provision of funds sufficient to maintain your comfortable standard of living. What makes you comfortable? It’s a very subjective standard, but it is still subject to a standard of reasonableness. Is it reasonable to use principal for food? Of course. But is flying to Thailand on a monthly basis for some amazingly authentic kang ka ree chicken a reasonable expenditure? Clearly not.

The IRS does not give any guidelines as to what constitutes a reasonable expenditure of exemption trust assets for support. It defines support on a case-by-case basis. I suppose the only guidance I can give you on how to recognize an infraction of this standard is this: Does it pass the smell test? If an expenditure looks wrong, and you harbor doubt about whether it is wrong, it is probably wrong.

7. You cannot use exemption trust assets for your support or health until you have exhausted your own Living Trust assets. Your share of the Living Trust assets is deemed to be part of another subtrust described and created by your Living Trust, called the “survivor’s trust.”

The Complete Picture

This chapter has focused only on your deceased spouse’s half, which you will allocate to the exemption trust to make it exempt from the estate tax. But to give you the complete picture of what happens to your Living Trust assets when your spouse dies, I need to discuss the other “shoe”—the survivor’s trust, which is your half of the Living Trust assets.

When your deceased spouse’s half of the Living Trust assets goes to the exemption trust, your half is automatically considered part of the survivor’s trust. The survivor’s trust contains your assets—your half. They are owned by you. You get income, principal, managerial authority to wheel and deal . . . whatever you want. Like the exemption trust, the survivor’s trust is also listed in the provisions of your Living Trust in the section dealing with what happens upon the death of one spouse.

Because you own the survivor’s trust assets, they are included in your taxable estate on your death. But, if your survivor’s trust assets do not exceed the exemption amount that exists in law at the time of your death, there will be no estate tax on those assets. Since the exemption trust is not taxable on your death, and since your survivor’s trust is taxable on your death, all of the expenditures for your support and health should be taken from the taxable survivor’s trust. If you run out of survivor’s trust assets, then at that point, and only at that point, you can then resort to exemption trust assets to provide for your support and health.

Whew! Those seven steps for exemption trust validity and effectiveness sound like a lot of work. Well, no one said this magic trick would be easy. But, as I say to my clients, once it’s done, it’s done. And if you have done the job right, you will save your family perhaps tens of thousands—maybe hundreds of thousands—of dollars in estate taxes on your death.

The Emergency Paragraph

Hang in there. I am almost done about the exemption trust. You have probably been to insurance seminars more exciting than this.

It is entirely possible that your Living Trust does not have provisions that create an exemption trust upon one spouse’s death. If this is the case, then all the assets in your Living Trust—your deceased spouse’s half and your half—will be part of your taxable estate on your death. As a result, you have lost an opportunity to prevent your Living Trust assets from being depleted by the estate tax. But don’t panic just yet. I am here to make sure that doesn’t happen.

Welcome to the emergency paragraph. If your Living Trust does not have exemption trust provisions, you can still prevent your deceased spouse’s half of the Living Trust assets from being counted in your taxable estate with an emergency procedure called a “disclaimer.” However, the rules of the disclaimer process are, in my opinion, even more onerous than the rules about maintaining an exemption trust. Perhaps the cure is worse than the disease. But what else should you expect in such a last-resort method of preventing your Living Trust assets from being taxed on your death?

In essence, the disclaimer is a document that says that you do not want your deceased spouse’s half of the Living Trust assets. Remember, you do not want them because if you get them, and you do not spend them prior to your death, they will be included in your taxable estate upon your death. Hence, the disclaimer prevents you from getting them.

That’s just as bad as it sounds. If you draft and sign this disclaimer, you do not get the assets you disclaim. And unlike the exemption trust assets, you do not get any use or authority over the disclaimed assets. No income. No principal. No wheeling or dealing. Instead, the disclaimed assets go to other people. Who? The ones you and your deceased spouse named as the backup beneficiaries in your Living Trust, such as your children and your siblings.

The disclaimer must be signed within nine months of your spouse’s death. If you don’t make the deadline, the disclaimer will be invalid.

Furthermore, you cannot validly disclaim any asset of which you have accepted the benefits prior to the disclaimer. In other words, after your spouse dies, if you gain access to any portion of the assets in any Living Trust bank or brokerage account, you disqualify that entire account from being part of the disclaimer process. Harsh, but true!

For example, let’s say that after your spouse died you went to the bank and withdrew some money from the Living Trust account to pay for your new membership at Match.com. That entire account is rendered ineligible for disclaiming because you used a portion of that account.

You will notice that I explained the disclaimer using examples involving financial assets. Intentionally so. One of the rare breaks given by the IRS in the estate tax arena is that you can disclaim your deceased spouse’s half of the Living Trust real estate (like the home) without you having to skedaddle from the home. You can reside in the house and disclaim half of that home both at the same time.

Putting All of This Estate Tax Stuff Together

Although I have presented you with an overwhelming amount of information in this chapter, the estate tax essentially boils down to the following.

The Federal Estate Tax Return

If your deceased spouse’s half of the family wealth (whether or not in the Living Trust) exceeds the exemption amount, you will need to run around and get information for your attorney so he or she can file an estate tax return.

An estate tax return must be filed even if no estate tax is due. The reason why no estate tax is due is because (1) your deceased spouse’s half of everything was allocated to an exemption trust, and/or (2) your deceased spouse’s half was allocated to you, the surviving spouse, or to a marital trust for the benefit of you, the surviving spouse.

As the estate tax stuff relates to the Living Trust, this is all you really need to know . . . for now! Just wait until the IRS actually imposes an estate tax. When is that? When you die! If you cannot wait for this other shoe to drop, jump ahead to Chapter 22, which discusses estate tax stuff that takes place after your death.

Allocation of Your Deceased Spouse’s Half to the Exemption Trust

Your Living Trust may contain provisions that, after your spouse’s death, establish two subtrusts: the exemption trust and the survivor’s trust.

The main purpose of the exemption trust is to preserve your deceased spouse’s exemption amount, which is the amount of assets established by law that can go to your Living Trust beneficiaries without the imposition of estate tax. While the assets in the exemption trust are used for the benefit of you—the surviving spouse—those assets that remain in the exemption trust on your death will be distributed to your Living Trust beneficiaries without any estate tax. Moreover, the appreciation on the exemption trust assets will also be tax-free.

But there is a catch to achieving the estate-tax-free status of the exemption trust. Actually, there are seven catches, because there are seven formalities in the maintenance of the exemption trust that must be followed. If those requirements are not met, the possibility looms that the IRS will disregard the exemption trust and consider those assets to be included in your taxable estate on your death.

The assets that are not allocated to the exemption trust are considered to be in the survivor’s trust. Whereas the exemption trust assets, for estate tax purposes, belong to your deceased spouse, you are the owner of the survivor’s trust assets, and, as a result, they are included in your taxable estate on your death.