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What is a Marital Trust and How Does it Work

A marital trust is typically part of an A/B trust or a credit shelter trust that allows wealthy families to minimize estate taxes. It is a practice previously employed by a lot of estate planning lawyers around 2010 and earlier when estate taxes were imposed on estates with a gross value of $1M and higher. Nowadays, federal estate taxes are imposed on estates above $12.06M. In New York, estate tax is imposed for estates above $6.11M. With these high exemption amounts, the need for bypass/marital trusts to minimize estate taxes has decreased. With estates higher than $6.11M, a bypass/marital trust may be beneficial depending on your objectives.

Who is subject to estate taxes

Estate taxes are imposed on the estate of individuals who have died if the value reaches a threshold amount. As of 2022, only estates above $12.06 million are subject to federal estate tax. In New York, the state estate tax exemption (or basic exclusion amount) as of 2022 is $6.11 million.

New York has an estate tax cliff which subjects the entire estate to estate tax if the gross value of the estate is 105% of the basic exclusion amount. In 2022, the estate tax cliff in New York is $6.4155 M. So if you are a resident of New York with a gross estate value of more than $6.11 M, any excess in above of $6.11 M is subjected to estate tax with the rate dependent on the excess amount. However, if the gross value of your estate is $6.4155 M, the entire gross value of your estate will be subjected to estate tax and not only that portion of the estate in excess of $6.11 M. This is how the concept of the estate tax cliff is applied. Thus, if you are a New York resident, it is always wise to ensure that the gross value of your estate when you die is less than $6.4155M.

A/B trust or credit shelter trust

In estate planning, an A/B trust or credit shelter trust is composed of two trusts, a marital trust and a bypass trust, designed to minimize estate taxes for wealthy families and typically created in the last will and testament.

Although the federal estate tax exemption is at $12.06 M, New York’s state tax exemption is lower at $6.11 M as of 2022. If you are a New York resident and the gross value of your estate is above $6.11 M, you may benefit from a bypass and marital trust.

If you want to minimize or eliminate estate taxes, you place your assets up to the amount of the exemption to a bypass trust, naming your heirs as beneficiaries. The rest of your estate is transferred to a marital trust, naming your spouse as beneficiary. The property transferred to the marital trust is not subjected to estate tax due to the unlimited marital deduction.

The unlimited marital deduction is a provision in federal estate and gift tax law allowing spouses to transfer property between each other during their lifetime or upon death without incurring any gift or estate tax.

For example, if you are a New York resident with assets worth $10 M and you want to eliminate the payment of estate taxes, you place $6.11 M of your assets in a bypass trust in your will, naming your spouse as a lifetime income beneficiary and your children as remainder beneficiaries. The $6.11 M in the bypass trust, falling under New York’s basic exclusion amount, is exempted from estate tax.

The remaining balance of your estate in the amount of $3.89 M is transferred to a marital trust, naming your spouse as beneficiary. Since it is a transfer to your spouse, the transfer is not subjected to estate or gift tax under the principle of unlimited marital deduction.

These trusts have to be written by an estate planning attorney. IRS has strict rules on language wording in trusts, especially with regard to the surviving spouse’s access to the bypass trust assets. In order for a bypass trust to be considered as one, for it to escape estate tax, and for it not to be included in the estate of the surviving spouse upon the surviving spouse’s death, the bypass trust has to be written in compliance with strict guidelines provided by IRS.The bypass trust allows you to provide for your surviving spouse and leave property to your children after the death of the surviving spouse without paying estate tax.

Income tax consequences

All the property transferred to the marital trust becomes part of the estate of the surviving spouse. The surviving spouse inherits the property from the deceased spouse with a stepped up (or reduced) basis, depending on the market value of the property at the time of the deceased spouse’s death.

In the example above, if at the time of deceased spouse’s death, the marital trust was funded with property in the amount of $3.89M, even if the deceased spouse had an acquisition cost for that property in the amount of $1M, the surviving spouse will inherit the property in the marital trust with a stepped up basis of $3.89M. In case the surviving spouse will sell the property in the marital trust for $4M, the surviving spouse will only pay capital gains tax on the gain of $0.11M.

If, however, the surviving spouse does not sell the property and dies with such property in the marital trust having a fair market value of $5M upon death, the surviving spouse’s heirs will receive the property with a stepped-up basis of $5M and not $3.89M.

Issues in practice

In practice, the rules for marital trust are usually straight forward and no major issues exist on its use. For bypass trusts, however, its use was regularly practiced before 2010, when exemption amounts for estate tax were at estates below $1M. Today, the need is less with the higher exemption amounts.

If you have previously executed a bypass/marital trust, however, one major issue you have to consider is that property in the bypass trust receives a stepped-up basis upon the first spouse’s death. The surviving spouse is then given limited access to the income and principal of the assets of the bypass trust, and for this reason, does not fall part of the surviving spouse’s estate. If the surviving spouse lives longer, the assets in the bypass trust may appreciate in value significantly. When the surviving spouse dies, the bypass trust assets are transferred to the remainder beneficiaries (usually the children) using the stepped-up basis at the time of death of the first spouse. This can result in significant income tax charges in case the bypass trust assets have significantly appreciated between the time of the first spouse’s and second spouse’s deaths.

For example, suppose the following: (1) a house worth $6.11M was transferred to the bypass trust upon the first spouse’s death; (2) the surviving spouse lives 15 years longer and at the time of the surviving spouse’s death, the house increased in value to $12M; (3) the children, as beneficiaries, receive the house of $12M upon surviving spouse’s death. In this case, the children receive the house with a basis of $6.11M, the value when the first parent died, even if they received it at a time when the market value was already $12M. If the children sell the house, they will pay capital gains tax on the gain of $5.89 M (12M less 6.11 M).

Given the significant income tax liability that the children, as remainder beneficiaries, may incur in a bypass trust, it might make more economical sense to put back the bypass trust assets into the estate of the surviving spouse so that the heirs may enjoy a stepped-up basis of the property at the death of the surviving spouse. If your deceased spouse previously executed a bypass/marital trust and you own assets in a marital trust, you need to review the tax consequences in case you keep the property in the marital trust against having the property in the marital trust being distributed to you so your heirs can receive a stepped up basis and will not be charged a significant income tax liability when they sell the property.

An estate planning lawyer will be able to help analyze your situation to determine whether putting back trust assets to the surviving spouse’s estate is a feasible option in the estate plan.

Other options

A marital trust is not the only method used to minimize or eliminate estate taxes. Irrevocable trusts where property is transferred during the lifetime of the decedent can also be used to minimize asset value, especially when you want to shield your property from creditors or you want to be eligible for Medicaid. Many grantors do not like irrevocable trusts because they do not want to lose control over their property, but when worded correctly, a grantor can usually retain control by giving a power of appointment to another person.

An easier way to transfer property to your beneficiaries is through joint accounts or joint tenancies with rights of survivorship. However, the proper method to transfer property to your heirs will really depend on your objectives and your desire for control. An estate planning attorney can devise an appropriate estate plan, depending on your assets and what you are seeking to attain.

In creating trusts, an estate planning attorney’s services are important because trusts require particular wordings, depending on your objective. For bypass trusts, particular words are required to limit the second spouse’s access to income so that such trust would be classified as a bypass trust. For Medicaid asset protection trusts, a different wording is required in order to protect the asset from Medicaid recovery.

An experienced estate planning attorney should be able to help you draft appropriate estate planning documents, which at the minimum should include a last will and testament, durable power of attorney, a healthcare proxy or power of attorney, beneficiary designations, and guardianship designations.

If your needs are a little bit more complex, you may also request for a trust. The estate planning attorney can recommend the appropriate given your objectives. Should you need assistance in planning your estate or the establishment of a trust, we at the law offices of Albert Goodwin are here for you. We have offices in New York, NY, Brooklyn, NY and Queens, NY. You can call us at 718-509-9774 or send us an email at attorneyalbertgoodwin@gmail.com.