When Will Modifications of a By-Pass Trust Be Respected for Basis Step-Up?

By Robin L. Klomparens¹

I. EXECUTIVE SUMMARY

The Tax Cuts and Jobs Act ("Act"), increased the basic exclusion amount under Internal Revenue Code ("IRC") section 2010(c)(3) from $5 million to $10 million indexed for inflation after 2011. The Act is scheduled to sunset in 2026, reducing the exclusion amount to approximately $6 million. As it is now, the basic exclusion amount is far greater than it ever was or was anticipated to be. Moreover, portability is also now available which no longer necessitates the use of a bypass trust ("B Trust") on the first death to utilize the first spouse’s exclusion amount.

Due to the higher exemption amounts and portability, most clients no longer need a B trust to avoid estate tax on the second spouse’s death. Assets in a B Trust do not receive a step-up in basis on the second spouse’s death. Using B Trusts also increase administrative costs. Hence, practitioners often propose termination of a B Trust if it is anticipated that no estate tax will be due. There are various methods used to terminate or modify a B Trust, but which of these will be respected by the Internal Revenue Service ("IRS")? Presumably the terminated assets will be included in the surviving spouse’s estate for estate tax purposes but is a step-up conditioned on the method of termination or modification?