Example of Misguided Use of Revocable Living Trust —

         $435,000 in Unnecessary, Avoidable Federal Estate Tax

          in a $2 Million Estate … An Almost 22% Tax Bite

Hypothetical Circumstances:

  1. Married couple with children.
  2. The couple had a net worth of $2 million, all of which was community property; neither spouse had separate property.
  3. The couple created a Revocable Living Trust (the “Family Trust”) and transferred all of their assets to it.
  4. The Family Trust provides that all the property passed in trust:
    1. To the survivor of them upon the death of the first of them to die (the “deceased spouse”), and
    2. To their children upon the death of the surviving spouse.
  5. The first of them to die died in 2002.
  6. The surviving spouse died later that year.
Husband: $1 million community half ———————— Wife: $1 million community half

 

First death:          Deceased spouse’s $1 million passed in trust to surviving spouse.

Surviving spouse now had $2 million of separate property (less any taxes, etc.).

 

Second death:          Surviving spouse’s $2 million passed in trust to children.

Children now shared $2 million of separate property (less any taxes, etc.).

“Probate” Results:

Success !!!  Both spouses avoided probate — all of their property passed “outside of probate” through their use of a Revocable Living Trust.

“Estate Tax” Results:

At the deceased spouse’s death, the deceased spouse’s estate was required:

  1. To file a Federal Estate Tax Return (Form 706), but
  2. Not to pay any federal estate tax, as the deceased spouse’s $1 million was exempt from federal estate tax for two independent reasons:
    1. The $1 million Applicable Exclusion Amount (for Decedents dying in 2002 & 2003, the first $1 million passes estate tax free), and
    2. The Unlimited Marital Deduction (generally, all property passing to a surviving spouse passes estate tax free).

Success !!!  The deceased spouse avoided both probate and estate tax.

At the surviving spouse’s death, the deceased spouse’s estate was required:

  1. Not only to file a Federal Estate Tax Return (Form 706), but
  2. Also to pay a federal estate tax, effectively on the amount in excess of the first $1 million (which passes estate tax free, due to the $1 million Applicable Exclusion Amount).

While he/she did avoid probate, the deceased spouse owed $435,000 in federal estate tax, reducing the children’s assets from $2 million to $1,565,000 — an almost 22% reduction.

This entire $435,000 payment of federal estate tax was avoidable !!!

It was required because the couple used a revocable living trust
providing for the surviving spouse to receive all of the deceased spouse’s assets.

What might have been some of this couple’s “mistaken beliefs” that cost their children $435,000?

  • Mistaken Belief #1: I can avoid paying estate taxes by avoiding probate.
  • Mistaken Belief #2: I can avoid paying estate taxes by using a Revocable Living Trust.
  • Mistaken Belief #3: Estate taxes apply only to those people who use a Will.
  • Mistaken Belief #4: Estate taxes apply only to probate estates.
  • Mistaken Belief #5: Both my spouse and I can avoid paying estate tax by giving each other our property.
  • And:
Ultimate Mistaken Belief:

“Avoiding Probate”

(a state property law issue)
has something to do with

“Avoiding Estate Taxes”

(a federal tax law issue)