The Five Main Estate Planning Options in a California Revocable Married Couple Trust: Balancing Income Tax, Estate Tax, Flexibility and Asset Protection Concerns

Marital planning in the joint trust context can be complex. Below we will examine the tax and non-tax implications of five main marital options upon the death of the first spouse. The options we will explore are: (1) leaving all property to a spouse in a survivor’s trust; (2) dividing the property into an A trust and B trust after the death of the first spouse; (3) leaving all of the deceased spouse’s property to the surviving spouse and including provisions for the surviving spouse to disclaim to a bypass trust; (4) leaving the surviving spouse’s interest in the trust in a survivor’s trust at the death of the first spouse and the dependent’s interest in a QTIP marital trust for the benefit of the surviving spouse; and (5) using a Clayton election after the death of the first spouse to plan for the possibility of estate tax and to protect the surviving spouse and eventual heirs of the descendent.

The five approaches outlined above are the most common forms of marital planning in the joint trust, but they often apply to separate trusts in separate property states as well.

Option 1: All to the Surviving Spouse:

The first option is the simplest. If husband and wife so desire, they can leave everything to the surviving spouse either outright or in further trust in a survivor’s trust. Directing property to a Survivor’s trust would allow the trust to continue without requiring the surviving spouse to later create a new individual trust after the death of the first spouse. With this option, the surviving spouse has full control over the trust property left to them by the deceased spouse. The surviving spouse may change the plan later by revoking or amending the trust.

For federal estate tax purposes, the entire trust estate is includible in the surviving spouse’s estate. If only one spouse’s estate tax exclusion is needed to shelter the entire estate, this may be a viable option for the couple. But other non-tax issues must be assessed as discussed below. The property owned in the survivor’s trust at the death of the surviving spouse also receives a basis adjustment when the remainder beneficiaries later inherit.

This type of plan is simple and effective, but it does have drawbacks. If the surviving spouse later remarries, nothing prevents them from changing the beneficiaries of the trust to the new spouse or the new spouse’s children, or from terminating the trust and moving the assets to a joint trust with the new spouse. Those assets could be later taken in a divorce.

There is also no asset protection for the surviving spouse over the deceased spouse’s share; the assets may be used to satisfy judgments in lawsuits, accessible to creditors or included in bankruptcy. But where husband and wife have a long, stable, single marriage, a smaller estate, and are not concerned with asset protection or remarriage issues, this may be a viable option. (One postmortem strategy may include porting the deceased spouse’s unused exemption amount through a portability election on a 706 Federal Estate Tax return, even when the estate is nontaxable.)

Option 2: Mandatory Bypass Trust:

The second option is to divide the trust estate into an A and a B trust through various marital deduction funding formulas. These formulas include the pecuniary marital formula, fractional marital formula, and the pecuniary credit shelter formula. Each approach divides the decedent’s estate into shares at his or her death, often creating a share covered by all or part of the decedent’s Applicable Exclusion Amount, and another share (or shares) covered by the unlimited marital deduction. Because these are mandatory funding formulas, the surviving spouse must divide the trust according to the formula at the death of the first spouse.

Years ago, this form of marital planning was quite common because the estate tax exemption was comparatively low. The main driver for this type of plan was the desire to use each spouse’s federal estate tax exemption (and often, where applicable, a state estate tax exemption). The surviving spouse’s estate tax exemption would be applied to the survivor’s trust – and any other assets owned in their name at death – and the deceased spouse’s exemption would shelter the bypass trust assets (and any assets passed outside the trust not going to the spouse).

When the federal estate tax exemption was fairly low, many families in America were motivated to establish mandatory marital deduction formula-based estate plans. For example, in 2001, the federal estate tax exemption was $675,000 with a top tax rate of 55%. With life insurance owned in the name of the decedent includible in this exemption calculation, many couples were almost forced into A/B trust planning to save estate taxes.

Today, with the option for a portability election on the 706 estate tax return at the death of the first spouse, the exemption can be used by a surviving spouse after the first spouse dies. But there are some limitations to relying on portability.

From an income tax perspective, creation of a bypass trust at the death of the first spouse has some drawbacks. Assets funded into the bypass trust receive a capital gains tax basis measured at the date of death of the first spouse to die, and do not later receive another basis adjustment when the survivor dies. For example, if a piece of real estate valued at $2MM at the death of the first spouse is funded into the bypass trust and remains there when the survivor later dies, any increase in value from the first spouse’s death until the date of death of the surviving spouse would be subject to capital gains tax liability upon sale.

This result can be avoided with creative planning, but the client must be advised of the income tax implications. For instance, if the surviving spouse sells the property from the bypass trust in exchange for a note, or if the survivor replaced it with other assets not subject to gain, the income tax problem can be mitigated.

Today, much of the planning around mandatory method A/B marital trusts involves larger estates. It may also enter the planning conversation where a spouse wants to ensure the eventual remainder beneficiaries originally chosen by the couple are not later disinherited. And often spouses seek asset protection for the surviving spouse from predatory creditors.

Option 3: The Marital Disclaimer Bypass Approach:

A third option is to design the trust to pass all of the trust assets to the surviving spouse outright or in a survivor’s trust and reserve the option for the surviving spouse to disclaim all or a portion of the decedent’s share to a B (bypass trust). A disclaimer is a refusal by someone to accept property that they are otherwise due to receive. The person signing the disclaimer (the “disclaimant”) makes an irrevocable and unqualified decision to refuse any interest in the disclaimed property. The disclaimer must comply with federal and state law. This type of planning is often referred to as “disclaimer trust” planning.

The disclaimer trust is a common form of “wait and see” planning for married couples. They may want to defer the decision to use a bypass trust for estate tax purposes or for asset protection for the surviving spouse. In a disclaimer trust plan, the surviving spouse may decide to disclaim property left to them by their spouse in trust, but they are not required to do so.  If the surviving spouse disclaims property received from the deceased spouse, the disclaimed property is transferred to the bypass trust.

The bypass trust is typically drafted so that the surviving spouse manages it as trustee and has access to income (and often principal, limited to the ascertainable standard of health, education, maintenance, and support, or “HEMS”).  As an exception under IRC §2518(b)(4)(A), the surviving spouse may benefit from the disclaimed assets in the bypass trust, but the assets are not included in the survivor’s gross estate when they die. If it were not for this, and possible asset protection of the disclaimed assets (depending on state law and the timing of the disclaimer), there would be little reason for a surviving spouse to disclaim. At the death of the first spouse to die, if the survivor desires asset protection for the assets disclaimed, creation of the bypass trust may make sense if the assets being disclaimed are not likely to trigger a later taxable gain, and even if the deceased’s spouse’s unified credit is not needed to mitigate estate tax.

The key advantage to this type of plan is the ability to assess the estate at the death of the first to die. The decision can be made then to create a bypass trust if the estate has grown significantly, if the estate tax exemption has decreased, or where asset protection is desired. The spouse may also decide to file a 706 and claim portability of the deceased spouse’s Unused Exclusion Amount (DSUEA).

If the surviving spouse appoints a third-party independent trustee over the bypass trust, the trust may contain a broader, non-ascertainable distribution standard, further increasing the asset protection for the bypass trust.

The obvious problem with a disclaimer trust plan is that the surviving spouse may fail to disclaim when it makes the most sense. They may also fail to disclaim because they do not obtain sound legal advice. This point becomes even more poignant when there is a blended family. The surviving spouse may later change his or her mind and decide not to disclaim the decedent’s assets to a bypass trust. Those assets may then be given to other beneficiaries that were never intended when the couple first established their plan.

The surviving spouse may also accidentally void the opportunity to disclaim. There are specific state and federal requirements that must be followed in order to make an effective disclaimer. For example, a disclaimer can fail if the surviving spouse manipulates the decedent’s assets in any way that constitutes acceptance of the property. This could happen if the surviving spouse moved the property from one account to another or sold the property and replaced it with another asset, for example. Another disadvantage is the lack of ability to grant the surviving spouse a limited power of appointment over Bypass Trust assets and therefore this type of marital funding formula lacks the flexibility that could provide in a plan.

Option 4: Survivor’s Trust/QTIP Trust Plan:

The fourth type of marital formula for a joint trust is the Survivor’s Trust/QTIP Trust Plan. This formula uses a forced Survivor’s Trust and QTIP Marital Trust at the death of the first spouse. The separate property (if any) and half of the community property in the trust are to be funded to a Survivor’s Trust at the death of the first spouse and the deceased spouse’s separate property (if any) and half of the community property are funded to a QTIP Marital Trust for the benefit of the surviving spouse during their lifetime. After the death of the surviving spouse, the assets that remain in the QTIP Trust are distributed to the beneficiaries the couple chose together. If the surviving spouse doesn’t amend the Survivor’s Trust, the assets of that trust will also be distributed to the beneficiaries that the couple selected together and named in the trust.

There are several advantages to this type of trust plan. First, all of the property in both trusts receive a step-up in cost basis at the death of the surviving spouse and therefore avoid capital gains tax for your children or other beneficiaries. What this means is that any assets that are subject to capital gains (for example, real estate, stock accounts, business interests, etc.) would have a new cost basis as of the date of death of the surviving spouse for the assets in not only the Survivor’s Trust but in the QTIP Trust as well. Additionally, the QTIP Marital Trust can add a measure of asset protection for the surviving spouse over the QTIP assets in the event of a lawsuit or bankruptcy where an independent Trustee is serving and protect the assets from a new spouse. The QTIP Marital Trust is also ideal for those who wish to maintain certainty that their children or other beneficiaries will eventually inherit their portion of the estate after the death of the surviving spouse.

The only potential disadvantages in general are two sub-trusts instead of one at the death of the first spouse and the requirement to file a 706 death tax return to elect QTIP treatment over the assets being funded to the QTIP Marital Trust. The QTIP election must be made by an independent executor at the death of the first spouse within 9 months of date of death, but this period is extendible by 6 months. The surviving spouse can appoint their attorney or CPA to make the election through the decedent’s Will.

To illustrate how this type of plan works practically, imagine Bob and Jane. Bob and Jane have two children each from prior marriages. They came into the marriage with about equal amounts in assets. They set up a Survivor’s Trust/QTIP Trust plan to help protect the first to die’s beneficiaries from later being changed by the surviving spouse. Bob passed away first leaving Jane a widow in her 70s. After a few years, Jane has met a new man and they get married. Jane wishes to leave her trust assets to her new husband. She can do this with regard to her Survivor’s Trust assets but not for the QTIP Trust assets as those are Bob’s assets left for the benefit of Jane for the rest of her life. There are a few different ways to craft the QTIP Trust. One way is to give Jane access to all of the income and principal of the QTIP Trust. Another is for her to only have access to just the income. Jane can be the Trustee of the QTIP Trust if Bob and Jane had agreed to that in the trust or a separate third party can be in charge of the QTIP Trust (or the third party can be a Co-Trustee with the surviving spouse after the death of the first spouse). The plan is quite flexible and can be crafted to match the intentions of the couple.

As of 2022, this plan is generally most appropriate for: (1) couples with a combined trust estate under $12,060,000; (2) those who do not anticipate a large growth in their joint estate value beyond $12,060,000; (3) couples with blended families; (4) those who would like creditor protection at the death of the first spouse for the surviving spouse; and (5) those who wish to protect the first to die’s estate for the reminder beneficiaries (so that the beneficiaries of the QTIP Trust cannot be changed in the absence of a Limited Power of Appointment). However, there is one note of caution, the Federal Estate Tax Exemption is set to sunset at the end of 2025, and the recommendation for fitness of this type of plan may change and be most appropriate for combined estates valued less than $5,000,000 (also note that the death benefit of life insurance policies that you own are also included in the value of your estate for Federal Estate Tax purposes).

Option 5: The Clayton Election:

Finally, we consider the Clayton election. This option provides more flexibility for A/B trust planning without all the limitations on capital gains tax treatment for bypass trust assets when the surviving spouse later dies. With this strategy, the plan is designed as A/B trust plan, but allows an independent executor to elect QTIP treatment over the deceased spouse’s assets by an election made on the decedent’s 706. The election may include up to the entire amount deceased spouse’s share.

Any property of the decedent for which the QTIP election is not made then funds the bypass trust. Assets in the QTIP trust would be includible in the surviving spouse’s estate at death, receiving a step up in basis at that time. If the beneficiaries later sell assets that were inherited through the QTIP trust, the capital gains tax liability is much lower (often zero).

The bypass trust and the QTIP trust can be drafted to be substantially the same. This way the spouse who dies first can ensure that the remainder beneficiaries of the trust are not later changed (subject to any testamentary power of appointment given to the surviving spouse).

If there is a long-standing marriage with joint children, the couple may want to give the surviving spouse a testamentary limited power of appointment to reallocate the assets of the QTIP or bypass trusts among their descendants, charities, and/or spouses of descendants. But in a blended family the couple may not want this provision because the surviving spouse could reallocate the bypass or QTIP trust assets, disinheriting the deceased spouse’s children or other beneficiaries.

Another advantage of the Clayton approach is that the election is made by an independent executor to avoid potential gift tax exposure by the surviving spouse. It also provides more objectivity in considering the benefits and drawbacks, especially in a blended family.

Because the Clayton election is made on a timely filed 706, the decision to send assets to the QTIP trust must be made within 9 months of the death of the first spouse to die. (A 6-month extension may be obtained, extending the time to make the election up to 15 months.)

There is an added cost to have a 706 prepared after the death of the first spouse, but on the whole, there are great advantages to the Clayton election. These include asset protection for the deceased spouse’s share, continuity of the remainder beneficiaries and an additional basis adjustment for assets in the QTIP trust after the surviving spouse later dies.

Because the Clayton election is made on the 706, this provides the additional opportunity to claim portability of the deceased spouse’s Unused Exemption Amount. In some respects, the couple can have their cake and eat it too.

The surviving spouse’s A trust property and the property in the QTIP trust is included in the survivor’s estate. Those assets receive a second step-up in basis when the surviving spouse later dies. But the survivor may also leverage the deceased spouse’s ported estate tax exemption in case it’s later necessary to use it. The survivor enjoys asset protection in the QTIP trust, and the “reverse QTIP election” can also leverage the deceased spouse’s GST tax exemption. (This is important because the deceased spouse’s estate tax exclusion is portable, but the GST exclusion is not.)

Flexibility is the key to the Clayton election’s power. For smaller and medium-sized estates, we won’t know the best course of action until the death of the first spouse to die. We may want to place assets that are rapidly appreciating into a QTIP so we secure a step-up in basis and avoid capital gains tax upon the death of the surviving spouse. Other clients may opt for the stronger asset protection features of a bypass trust, especially if capital gains exposure is not a major factor when funding the plan after the death of the first spouse.

It is important to note that using portability to preserve a first spouse’s exemption has some flaws. The DSUEA does not adjust for inflation, and it may be lost upon remarriage of the surviving spouse. In this scenario, using a bypass trust may make more sense to preserve the use of the DSUEA. (But the survivor may also use the DSUEA to fund an irrevocable trust after the death of the first spouse, using the DSUEA proactively, rather than by a default bypass trust.)

Protection for children from a prior marriage is arguably superior with a bypass trust as well since we would not be at risk of an independent executor failing to make the QTIP election. Allocation of the deceased spouse’s GST exemption to a bypass can be more easily accomplished as well.

So Which Approach is “Best”?

There are several “soft” issues to consider when recommending a plan to a client. These issues include the desire to provide asset protection for the surviving spouse and to preserve the jointly chosen remainder beneficiaries after the death of the first to die.