How can I update or modify my old California estate plan that involves an irrevocable trust?

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Answered by: D. Michael Trainotti

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Establishing an estate plan in the first place can be a costly and time-consuming process. The idea of updating it years later, when your situation may not feel much different, may not be attractive. In fact, in the past, updating certain estate plans has been impossible due to the structural regulations. However, recent change in tax law means that, in some cases, it is now easier to modify your plan, and you should update your estate plan to be in date and to avoid paying additional taxes.

The balance between avoiding estate tax and embracing capital gains

In the past, the mantra for estate planners has been, “better to avoid estate tax now even if it means deferring capital gains later.” This means, design an estate plan to avoid the heirs having to pay tax out of the estate, even if it means losing potential profit on the sale of property or assets in the future because you have to pay tax on it. Estate taxes are often high, and would outweigh the profit your heir may make. However, there has been a significant increase in the amount you are able to transfer to your heirs free of tax (called the “applicable exclusion amount”); now, you as an individual may pass down up to $11.18 million. This means that, in some cases, the measures taken to avoid paying taxes are now unnecessary and can in fact cost your heirs money.

Here’s an example. John owns a rental property, valued at several million dollars. He wants to pass it down to his daughter, Judy. In the past, his lawyer may have put it in what is called a “grantor trust” to avoid Judy having to pay tax on something that exceeded the applicable exclusion amount — trusts are often used this way. However, say that John passes away and Judy wants to sell the property. Now, it is worth double than it used to be. Because it is in this type of trust, it is not eligible for estate tax, but it is eligible for capital gains tax, which means a tax on the sale of the property. The federal and California combined highest capital gains tax rates (federal being 20 percent and 3.8 percent, California being 13 percent) equal 36.8 percent, compared to the 40 percent estate tax that is not applicable. Depending on the sale price of the property, this could mean Judy is paying millions in tax.

If John changed his estate plan to be in date with current tax law, he could have avoided that cost for his daughter. Since the applicable exclusion amount has grown, he could have passed that property to Judy and she could have sold it with no capital gains tax.

So, it is advantageous to change the structure of your estate plan. However, in the past, irrevocable trusts such as a grantor trust are unchangeable – that is the meaning of “irrevocable”. Is there a way to modify this plan to get the tax advantages?

How the new tax law allows irrevocable trusts to be changed

In the recent tax overhaul, California modified Probate Codes §§ 15403 and 15404 to allow irrevocable trusts (such as bypass trusts, which are established on the death of a spouse, or asset-freezing trusts, established to freeze assets values of highly appreciating assets on the death of parent) to be modified and/or terminated based upon beneficiaries’ consent. 

Probate Code §15403 is used when the parent is deceased but his or her spouse and or children are still alive. Probate Code § 15404 is used when the parent who created the irrevocable trust is still alive and so are the beneficiaries. Probate Code § 15404 can be used without having to go to court under certain circumstances, compared to Probate Code §15403.  In the above example, John and Judy could terminate the grantor trust under Probate Code § 15404, without having to go to court.

Why you should review your plan

It is always worth revisiting your estate plan every so often to ensure that it is still up to date and will still work the way it is meant to. Whether you meet with your original attorney who drafted the plan, or take your plan to a new attorney to get fresh eyes on it, I would always recommend checking your plan more frequently than you may think is necessary.

Disclaimer: The answer is intended to be for informational purposes only. It should not be relied on as legal advice, nor construed as a form of attorney-client relationship.

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