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"Stale" or "unfunded" bypass trust on second spouse's death:
First spouse dies in 2006 when exemption equivalent was $2,000,0000. Total value of couples assets were $3,000,000 so decedent's 1/2 was 1,500,000 and no 706 was required. All assets were held in family trust calling for bypass/exemption equivalent trust to be set up on first spouses death but no asset transfers happened and no sub trusts were funded. Surviving spouse dies in 2008 when total assets are still worth 3,000,000.
The beneficiaries of the bypass trust and the survivors trust are the same
Realizing there could be a myriad of fact patterns and approaches, is there a preferable method of reporting on the second spouse's death? e.g. should a 706 be filed reporting the full value of all of the assets and taking a deduction for a claim by the bypass trust or its beneficiaries for the value of what should have been funded to the bypass trust. Or, should there be an actual late funding of the bypass trust and no 706 filed? OR, should there be a late funding of the bypass trust and a 706 filed disclosing the late funding and reporting only the survivors share of the assets even though they are under the 2,000,000 filing requirement (to hopefully get a closing letter from the IRS)? Or something else?
Do we actually have to go through the machinations of funding and retitling assets to the bypass trust with its share and then distributing to the beneficiaries rather than just distributing the assets directly from the existing accounts?
Does anybody know what the IRS's current thinking on this is?
Thank you for your input.
Richard Cassidy, CPA
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Wow, Richard. You always have the "good" ones! Please register!
A few of us from the L.A. Chapter Estate Planning Committee could speak with you at length about this. Let me offer a few comments and ask a few questions:
1. My understanding from listening to IRS attorneys at our Feb meeting over the years is that they expect actual title transfer and funding eventually. It is not in your client's interest to ignore the terms of the trust for expediency.
2. Does the bypass trust get the pecuniary amount, or does the survivor's trust get a pecuniary amount (if necessary) to lower the estate tax to zero?
3. While the assets are in the terminating living trust, the separate property and 50% community interest of the survivor get taxed to the survivor, and the separate property and 50% of the community interest of the decedent get taxed to the trust. You probably have amended returns to file.
4. How hard is it to account for everything since the first death?
5. Google "stale trust" for one of Hartog's articles about this. His treatise is very useful for attorneys and accountants practicing in this area.
John Jacobson
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| I attended a Cal Society Estate conference many years ago where an IRS agent named Richard Ludlum, spoke to the audience. He made the statement that if the bypass trust had never been funded five to ten years after the first spouse died, then the estate representative better have a good excuse, or otherwise he will include all assets in the second to die's estate. With the first spouse dying in 2006 and the second dying in 2008, it seems that one could make an argument that it wasn't administratively possible to fund the trust, especially if the surviving spouse was temporarily the trustee. I would divide the trust assets 50/50, get an EIN for the bypass trust, and file a first and final return for it. I would not file a 706 for the second to die, due to the gross assets being under the filing amount.
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| Retired estate tax attorney, Joe Stemach, at a CalCPA program said that when the trust is unfunded at the second death, he (and his colleagues) would allow a deduction for a liability equal to the amount that should have been funded. Many people were upset because he said that no allowance would be made for any appreciation that had occured between the first and the second death. I've prepared delinquent 706 forms when the surviving spouse thoght she didn't have to do anything when her husband died because "everything was in a trust to make it simple." In the last one I prepared, there was a gain on funding because the surviving spouse received more than she would have with a timely funding.
Mary Kay Foss
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Thanks all for the comments.
John: I registered here a couple of years back, before the format change, and something happened to my file. Now when I try to register it tells me my e-mail address is already registered. When I go through the lost password routine it says it will send my password to my e-mail address but it never shows up. I gave up on trying to figure it out, although I would like to register in order to edit my posts.
Your item 1 and Mary Kay's comments are interestingly opposed. If we can follow Joe Stemach's approach and show the unfunded trust as a liability it would be easier than going through formal title transfers. But I know the easy way is not usually the right way.
Your question 2 is is an interesting one in this case because the trust has two provisions. It first calls for an exemption equivalent pecuniary formula and marital residue with date of distribution values and in the next section says marital deduction pecuniary formula and exemption residue with allocation at federal estate tax values. I think the attorney must have had the option of two canned provisions and put in both by mistake. Great drafting!
We may have some income tax issues. The prior accountant has ultimately included all of the income on the survivor's return. For some reason he has filed a marital trust income tax return and shown all of the income passing through to the survivor. Where he got the idea for a marital trust I'll never know. There just aren't enough assets to need one.
Accounting since the first death would be doable, but of course, the client doesn't really want to pay for it if it could be avoided.
I've read the item from Hertog I found on the internet. It doesn't seem to provide a direct answer. (I know there isn't one). There is a very good write up on unfunded bypass trusts by Mickey R. Davis that provides some alternate approaches. One is the claim against the estate approach but it is based on Texas law and, this being California, I don't know how much to rely on his case cites. Its a good article though.
Mike: That's a possible approach. My partner was at an estate course recently and put the question to Mel Kreger who suggested a course very similar to yours. I'm a little uncomfortable with that though. I'd like to file a 706 to make sure the IRS doesn't come back to bite at some later unexpected time. The trustee doesn't want that kind of personal liability.
Mary Kay: That's comforting to hear that Joe Stemach said that he would allow a deduction for the liability to an unfunded trust. We could do that and, because of the values here, not have to worry about the appreciation, at least for estate tax purposes. There has actually been some depreciation due to the real estate market.
I'm late for the debate. Thanks again to you all for the comments.
Richard Cassidy
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I think everyone is on the same page. A lot depends on the wording of the trust.
Put yourself in the shoes of a child from a prior marriage suing the surviving spouse's estate or the terminating trust to fund the bypass trust.
If the bypass trust was the pecuniary amount, and it was obvious that the estate on the first death was more than twice the exemption equivalent amount, then the IRS auditor could be talking about a quick and dirty way of calculating the survivor's taxable estate. Legally, it is the liability from the terminating trust to the bypass trust.
But what if the bypass trust was the residue? My guess is the IRS auditor's theory is that the surviving spouse breached the trust, and had a liability to repay, estimated by the value of the exemption equivalent amount at the first death. "Breach" may mean not being able to account for the decedent spouse's interest in the community, as opposed to actually removing the assets from the trust. (But if the trustee can account for some assets, like realty, then the estimated value could change.) If the trustee cannot account for what comprised the decedent spouse's interest in the community, the only alternative is to quantify it as a $$ judgment.
A similar fact situation happened in a West Virginia case (I don't remember the cite) decided a few years ago, in which the s/s took most of the assets out of the bypass trust, titled them into his own name, and mixed them with his own. (He was a day trader.) His children filed the 706 without any liability back to the trust, and then amended the return to show the liability. Interestingly, the court denied the deduction because the trust did not file a timely creditor's claim in the decedent's probate estate.
If you can account, and by account, I mean specifically identify the decedent's interest in the community and what happened to it since death, I don't think the trust has been breached in your fact situation. It is only a matter of accounting for each half of the community and accomplishing the next steps. So including the first decedent's assets in the surviving spouse's taxable estate wouldn't follow. (Note also that including the first decedent's assets in the estate means they would be stepped up at the second death. That does not make sense unless there is a breach.)
John Jacobson
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| I'd be extremely wary of anything Mel Kreger says. He has steered us, and several friends, very wrong with estate advice.
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Richard,
I have recently had a client come into my office with almost identical circumstances as your blog posting of 10-1-08. I am interested in what answers you have come up with.
Rick Embertson, CPA
Remberts@embertsoncpa.com
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