Stepped-Up Basis

Whenever a person sells an asset, whether personal or real, the person needs to determine cost basis of the item to ascertain whether or not the sale results in a taxable gain. For example, John purchases 118 Green Street in CA for $100,000 in 1985. The cost basis would be $100,000. If, generally speaking, John ever sold the property for greater than $100,000 such sale would result in a taxable gain.

One of the prime benefits of acquiring real property through inheritance is the application of "stepped-up basis." The result of stepped-up basis is that a person who inherits real property receives a new cost basis which is pegged to the fair market value of the asset at the date of the decedent's death. IRC §1014(a); Rev & T C §18031. Yes, that is how it is written in tax terminology. For example, from above, John purchases 118 Green Street for $100,000 in 1985. Due to real estate appreciation (just go with it), John's home gradually increases in price to $700,000 in 2012. John then dies in a tragic hot air balloon accident in 2012 in Morgan Hill, CA. John's heirs would be entitled to claim $700,000 as the cost basis of the home. Subsequently, when John's heirs sell the home, the starting point for a taxable gain would be $700,000, whereas the starting point for John would be $100,000. Though capital gains tax is much lower than regular income tax (see Mitt Romney tax return for 2010), it still is roughly 25% combined for federal and state, that is California. When you multiply that by 600,000, the result is a rather large number. Thus, it is quite clear that stepped-up basis affords heirs an enormous tax savings because they are not liable for the appreciation that has accumulated over the years. Rather, the heirs can take advantage of the new date of death value of the asset. The common result is that heirs of real property often pay little to nothing in capital gains taxes if they sell the inherited property shortly after receiving it. 

Suing a Trust

One of the more common fallacies in regards to trusts is the notion that a trust itself is the appropriate party to sue. Instead, the trustee of the trust is the appropriate party to sue. This distinction was raised in a recent California court case with unfortunate results for one party.

Portico Management Group, LLC v. Harrison (2011) 202 CA4th 464

Portico Management Group, LLC contracted with the Harrison Children's Trust and the Harrison Family Enterprise II, a limited partnership, to purchase an apartment building it owned jointly. Naturally, the sale was never completed and Portico sued the Trust and limited partnership, and ultimately was awarded $1.6M through arbitration. In 2007, Portico had the arbitration award entered by the trial court but judgment was entered against the Trust rather than the Trust's trustees. Portico then sought to enforce the judgment against the Trust but the Trust's trustees objected because Portico had obtained a judgment against the wrong party, the Trust as opposed to the Trust's trustees. The trial court ruled in trustees' favor and Portico appealed. 

The appellate court affirmed the trial court's decision because the trustee is the real party in interest, not the trust itself, and thus judgment had been entered against the wrong party. Still, even though the arbitrator incorrectly listed the wrong party as the judgment debtor, Portico had an opportunity to correct this mistake by either utilizing the arbitrator or the trial court within certain time periods. Yet, Portico failed to act in a timely manner and deprived itself of the opportunity to correct this mistake. Thus, the appellate court ruled that Portico could not levy upon trust assets for recovery.

The obvious takeaway from this case, is that if a litigant ever sues a trust, they must name the trustee in the complaint or else you might end up with a judgment against an entity, namely a trust, that does not fall within the statutory definition of a judgment debtor and recovery will be thwarted.   

Modifying an Irrevocable Trust

The Berkeley Court handles probate matters in Alameda County

Though the name suggests otherwise, an irrevocable trust can be modified through a number of ways. A previous post discusses how to amend a revocable trust. The following are permitted methods to change a California irrevocable trust. Most of the methods do require court approval.

1.  All trust beneficiaries consent. Prob C §15403.

This method is generally allowed provided that neither of the following apply (1) "the continuance of the trust is necessary to carry out a material purpose of the trust, the trust cannot be modified or terminated unless the court, in its discretion, determines that the reason for doing so under the circumstances outweighs the interest in accomplishing a material purpose of the trust.the modification will not" or (2) the trust contains a spendthrift clause.

If neither (1) or (2) apply, the beneficiaries can petition the appropriate probate court for modification. 

One of the problems with this method is that sometimes beneficiaries do not live in the same area or there are beneficiaries that are minors or unborn. Thus, obtaining the consent of all beneficiaries can be a challenge.

2. All trust beneficiaries and the settlor consent. Prob C §15404(a)

Generally speaking, no court order is needed for this method. 

3. At least one beneficiary and the settlor consent. Prob C §15404(b)

This method is allowed provided that the interests of the non-consenting beneficiary or beneficiaries is not substantially impaired.

4. Principal is uneconomically low. Prob C §15408

Following the submission of a petition to the court, if it "determines that the fair market value of the principal of a trust has become so low in relation to the cost of administration that continuation of the trust under its existing terms will defeat or substantially impair the accomplishment of its purposes," modification is permitted.

Or, if the trust principal is $40,000 or less, the trustee is empowered to terminate the trust immediately.

5. Changed circumstances. Prob C §15409

This is most common with charitable trusts as a settlor might name a charity as a trust beneficiary but the charity merges with another charity or dissolves prior to death. For example, assume that Samuel Settlor designates an animal shelter in Los Altos, CA as the sole trust beneficiary. Prior to Samuel's death, the animal shelter dissolves for lack of funds to operate and donates its remaining assets to the animal shelter in Mountain View, CA. Upon Samuel's death, the Mountain View animal shelter would petition the probate court to modify the trust whereby it would become the trust beneficiary because of its connection to the Los Altos animal shelter. 

The legal term for substituting one charity for another to fulfill the settlor's intent in a trust modification case is called "cy pres." Try to incorporate that term into your conversations to either (1) impress your friends, co-workers or family (2) confuse them or (3) raise their ire by using legal jargon in an every day conversation.  

6. Conform the trust to tax laws. Probate Code §§21520-21526

Since a principal reason to write a trust is consideration of tax laws, a trust can be modified to achieve the tax objective the trust was intended to fulfill.

Types of Irrevocable Trusts

The majority of trusts that are drafted are known as revocable or living trusts. However, some people write irrevocable trusts as well if the situation dictates the necessity for such. The following are some of the more common irrevocable trusts:

Life Insurance Trust (commonly known as a ILIT)

In this type of trust, parents gift money to their children to pay the life insurance policy premiums, which are taken out for the parent's lives, and the parents then designate the children as the policy's beneficiary. An ILIT provides the benefit of reducing the parent's taxable estate for Estate Tax purposes and provides the children with liquidity to satisfy Estate Tax obligations. For example, the parents might gift $26,000 to their children annually to purchase the largest life insurance policy they can obtain. When the parents pass away, the proceeds from the policy will not be included in his or her gross estate for Estate Tax purposes. In turn, the children will reap sufficient liquidity to pay any Estate Tax liability. Generally speaking, the IRS requires prompt payment of the Estate Tax, hence access to large quantities of cash is needed to pay it. Unfortunately, you cannot barter services with the IRS as a form of payment so money is needed to pay them off not your impressive karaoke skills.  

Crummey Trust 

This type of trust allows a parent to gift the maximum annual exclusion amount, $13,000 in 2012, to their child's trust. The name is derived from the court case which recognized its validity, Crummey v Commissioner (9th Cir 1968) 397 F2d 82. Basically, a parent tells their child that they are gifting their Crummey Trust $13,000 and the child has the right to withdraw said funds within a specified time period if they so desire. Invariably the child will not withdraw the funds whereby the funds become part of the child's trust. If this seems like a big charade to you, then you can think prudently. 

Charitable Trust

Since the Estate Tax allows a charitable deduction, a wealthy individual might write a trust which benefits a recognized charity to offset the Estate Tax. There are two types of these, a charitable remainder trust ("CRT") and a charitable lead annuity trust ("CLAT"). In a CRT, individuals are designated as beneficiaries for a specified period of time, with the remainder interest passing to charity. In a CLAT, the formula is reversed, the charity is the initial beneficiary for a specified period of time, with the remainder interest passing to named individuals. 

Special Needs Trust (commonly known as SNTs)

A SNT is a trust designed for individuals who are disabled with the goal of retaining the individual's public benefits such as Medi-Cal and Supplemental Security Income while simultaneously allowing them to receive property. There are two types of SNTs, a First-Party Specials Needs Trust and a Third-Party Special Needs Trust. In a First-Party SNT, the disabled individual themselves creates the trust. For example, the individual is awarded a substantial judgment for a personal injury claim and creates the First-Party SNT to maintain eligibility for public benefits. Conversely, with a Third-Party SNT, some person other than the disabled individual, almost always the parents, creates the trust for the individual. 

Qualified Domestic Trust (commonly known as a QDOT)

In the case of a couple, the Estate Tax is not an immediate concern should one spouse away. The reason for this is because one spouse is allowed to transfer to the surviving spouse an unlimited amount of property upon their passing. IRC §2523. For example, if Jack and Jill were collectively worth $250M and Jack suddenly passed away in a tragic hot air balloon accident, Jill would have no immediate concern of paying the Estate Tax since Jack could leave his entire to her absent Estate Tax liability. Although Jill's estate would have to pay the Estate Tax once she passes away. Regardless, the major qualification for the unlimited marital deduction is that the surviving spouse be a U.S. citizen. IRC §2056(d).

If the surviving spouse is not a U.S. citizen, the couple can write a QDOT to take advantage of, albeit partially, the marital deduction for Estate Tax purposes. The nuances of a QDOT are beyond the scope of this brief post because the requirements are rather technical and more importantly for you the reader, quite boring. However, a prior post is dedicated to this topic.   

There are many other types of irrevocable trusts. I focused on the above trusts because I see them in use most frequently.