Is there a tax trap in your trust?

The estate tax exemption amount gets a lot of press, but that isn’t the tax provision most folks need to be aware of in estate planning.

In 2024, the estate tax exemption — the amount anyone can pass to anyone at their death without incurring estate tax — is $13,610,000. For a married couple, that means more than $27 million can be passed on, estate tax-free. Are you worried about estate taxes?

In 2025, the current law expires (assuming Congress does not pass any new changes) and the exemption dips to about half those amounts. Worried yet?

The fact is, most people do not have estates in excess of $7 million and don’t have to worry about estate taxes. But there is an income tax issue that might affect your estate if your trust is outdated or not drafted properly in the first place.

The old way

Prior to 2010, a common trust provision would split the trust into two at the death of the first spouse. These trusts were commonly known as A/B trusts or the survivor’s trust and a second trust known as either a decedent, credit shelter, or bypass trust. There were, generally, two reasons to split a trust at the first spouse’s death.

The first was to ensure the surviving spouse did not change the beneficiaries and leave everything to the hot new cabin boy or girl (ie, the new spouse).

The second was so that each spouse’s estate tax exemption could be utilized. Back then, the use of both spouse’s exemptions was very important, as the exemption amount was much lower than it is now. For example, in 2002, the exemption amount was $1 million, rising to $3.5 million by 2009.

Pre-2010, if a married couple with a $5 million estate had a trust that said, “I leave everything to my spouse,” two bad results could occur. First, the surviving spouse could remarry and leave everything to the new spouse, disinheriting the children. Or, assuming the spouse does not do that, at the surviving spouse’s death there would be an estate tax on the value of the estate in excess of the surviving spouse’s estate tax exemption — the first spouse’s exemption was unused and lost.

Since nobody liked either of those outcomes, the A/B trust was the solution. The B Trust held the deceased spouse’s share of assets, was irrevocable, and used that spouse’s estate tax exemption. This may no longer be the best plan.

What changed?

In 2010, the Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010 (“TRA 2010”) was passed, and the concept of “portability” of the estate tax exemption of the first spouse to die became a reality. In essence, a surviving spouse can file an election at the death of the first spouse, preserving the deceased spouse’s estate tax exemption to be applied later, without the need for a separate trust.

Additionally, the Tax Cuts and Jobs Act raised the estate tax exemption from $5,490,000 in 2017 to $11,180,000 in 2018. Since then, we have seen the exemption rise to $13,610,000 in 2024 due to inflation. As a practical matter, this means most married couples don’t need both spouse’s exemption amounts.

Thus, a married couple may no longer need to split their trust into two at the first death, merely for tax purposes. And in fact, there may be a capital gains tax downside to an A/B trust split.

Capital gains tax trap

When one spouse dies, all assets of the married couple get a step-up on income tax basis.

For example, if you have an asset you bought for $100, your basis is $100. If you sold it for $1,000, you’d have $900 of capital gain. But if that stock is worth $1,000 at the death of one spouse, the new basis is $1,000.

The beneficiary can turn around and sell that stock at $1,000 with no gain. At the death of the second spouse, there is again a step-up on income tax basis. However, assets that are in a “B” trust (ie the assets of the first spouse to die) do not receive another step-up on a basis.

This can result in significant capital gains upon sale of those assets, particularly if there is a long time between the deaths of the spouses.

Don’t disinherit my kids

You may be thinking, “Sure, I don’t need it for tax purposes, and I don’t like that my kids might pay more in capital gains taxes, but I still don’t want my surviving spouse running off with the hot cabin boy or girl and disinheriting my kids. I still want my half of the assets protected in a trust my spouse can’t change.”

If that’s the case, you may want to update your trust so that the share of the first spouse to die is held in another type of trust—commonly known as a marital trust.

This is a trust drafted to protect the contingent beneficiaries (eg, the children) but also be included in the surviving spouse’s estate such that the assets will get a second step up on income tax basis. This can give you the best of all tax worlds.

As with everything having to do with taxes, planning can be complicated. There is no “one size fits all.” The tax laws are constantly changing, and your personal situation is likely too. That’s why it’s a good idea to check in with your advisors and review or create your trust accordingly. The tax tail doesn’t need to wag the dog, but you also don’t want unnecessary tax bites.

Teresa J. Rhyne is an attorney practicing in estate planning and trust administration in Riverside and Paso Robles She is also the New York Times bestselling author of “The Dog Lived (and So Will I)” and “Poppy in The Wild.” You can reach her via email at Teresa@trlawgroup.net