Ease the tax burden on your heirs (part 2)

In the first installment, we outlined possible tax problems caused by irrevocable trusts. Undoing a trust isn’t always feasible, but if there’s an irrevocable trust in your family, it’s worth talking to an attorney to see if something can be done.

For instance, if the irrevocable trust is a grantor trust – one that is taxable to the donor – then in some situations, Sally might be able to “swap” assets in the trust.

Suppose some of the trust assets have greatly appreciated in value and have a low basis. If Sally owns other assets that haven’t appreciated in value and have a high basis, she could “take back” the low-basis assets from the trust, and pay for them with the high-basis assets. As long as the assets are of equal value, there might not be any problem with this – but the resulting capital gains taxes would be greatly reduced.

In the past, many couples’ wills created a trust at the death of the first spouse. This trust provides income to the surviving spouse during his or her life, with the assets going to the children when the second spouse dies. In such a situation, it might be possible to selectively distribute low-basis trust assets to the surviving spouse, to move as many of them as possible into his or her estate and out of the trust.

There’s even a technique in some cases whereby Sally could “appoint” the trust assets to go instead to an elderly family member – let’s call him Phil – with a short life expectancy. Phil would then appoint the assets to go to Jim when he dies. The trust assets would get a step-up in basis at the time of Phil’s death. As long as the assets aren’t large enough to cause Phil’s estate to owe any estate tax, everyone benefits. (This technique is tricky, though, and only works in limited circumstances.)

Finally, if the trust’s terms don’t allow any of these alternatives, it might be possible to move the assets into a new trust with different rules. This is sometimes called “decanting” a trust, because the assets are being poured from an old container into a new one. Some 22 states currently allow decanting of irrevocable trusts in at least some circumstances.

In any event, it’s worth taking a second look at any irrevocable trusts, so that yesterday’s tax savings don’t become tomorrow’s tax nightmare.