your family trust in california has a big tax problem, and your kids will foot the bill
December 9, 2024
By Marc Joyce, Principal Attorney
To learn about my simple and modern approach to family trusts and estate planning, click HERE
Email: marc@catrusts.law Phone: (310) 780-8614
Marc is a California trust attorney practicing in complex trust administration and tax-focused estate planning. Marc graduated from UC Irvine and Loyola Law School, then joined Gaw Van Male, LLP in Napa, California before moving back to Los Angeles to open CA Trust Law, APC.
THERE CURRENTLY EXISTS a huge, unseen tax problem lurking in many California family trusts, and very few people are aware of it. The tax problem is extremely specific: it affects revocable, living or “family” trusts which were established by married couples in California at some point in the past, and where one spouse has now died. Those trusts are at high risk.
If you are a surviving spouse with a family trust, or one of their children, or if you know a family that has lost a spouse, then please pay attention, because those trusts could be at very serious risk of incurring high capital gains taxes. This result might be particularly awful because those taxes might be avoidable and the problem might yet be fixable, if you act before it’s too late.
THE PROBLEM
Here’s the problem: many of these family trusts were structured in such a way so that when the first spouse died, the family trust would divide into two different “parts,” one part for the spouse that died, and one part for the surviving spouse. Practitioners sometimes call these parts “shares” or “subtrusts.”
There are different ways California trust and estate attorneys might structure a family trust, but this has been a particularly common method for married couples in California, and so if you are a surviving spouse who created a trust with your husband or wife before they passed away, then there is a very good chance you have this kind of trust.
And there was probably good reason for doing so at the time, when the tax laws in the country were very different than they are today in 2024. The drafting attorney at the time may have been concerned with estate taxes, and wanted to structure the family trust this way in order to defer the payment of any future estate taxes until after the death of the 2nd spouse.
Chances are though, under current tax laws, that kind of trust is no longer needed for its originally intended purpose (now that the federal estate tax exemption has skyrocketed), and it now poses only a very serious capital gains tax risk to the beneficiaries (i.e. the children) when the surviving spouse passes away.
This is because only the surviving spouse’s “part” of the trust will receive a “step-up in basis,” which is a highly beneficial IRC tax treatment which avoids all capital gains, both state and federal, that occurred in the time between the deaths of the first and second spouse, which can be enormous.
AN EXAMPLE
Here’s an example: let’s say that years ago, a married couple in California created a revocable living trust for their benefit and for their children's benefit if they died. Let's say husband died a few years later, and wife is still alive today. Let’s say that when husband died, the trust estate was worth about $2 million between a house and some other common assets like stocks and bonds. Husband's "part" of the trust was worth $1M, and wife's (surviving spouse's) "part" was also worth $1M at the time.
Now let's assume that the trust assets have continued to appreciate in value after husband died, and when wife passes away in a few more years, the trust will be worth $4 million total. Now, when wife passes away, after both “parts” of the trust have appreciated in value and grown to $2M each, the husband’s $2M "part" will be subject to capital gains taxes on the entire $1M growth, resulting in a tax bill of approximately $369,177. What a horrible result! That's $369,177 taken right out of your kids' inheritance and given to the government. This is the lurking tax problem in many California trusts established by married couples. Here's a video to illustrate:
Certainly the tax problem can be far worse depending on the situation. And the solution isn’t easy - the surviving spouse typically cannot simply amend or change the family trust to correct the problem because typically they can only amend their “part” of the family trust, and the deceased spouse's "part" is irrevocable.
But there may be a solution, but the surviving spouse must act now during their lifetime, because if you don’t, your children will be unable to do so once you’ve passed away – it will be too late then.
THE SOLUTION
The solution comes in the form of a technical trust modification by court order. I can help the surviving spouse petition the court for a trust modification to insert very precise IRC code language into the deceased spouse's "part" of the trust, which qualifies that part for the beneficial "step-up in basis" tax treatment I describe earlier – it’s an expert, state-of-the-art legal cure for an extremely specific trust tax problem currently affecting many people in California (particularly the kids) who don't know about it. This is real lawyering.
I truly love providing this specific service to clients because I get to help them solve a unique and difficult problem, and because the value of my work sells itself. Just do the math and run some projections - I don’t need to use sales techniques or pressure clients into engaging me because in nearly every one of these cases, although my work is not cheap, the value is so high and clear compared to the projected tax savings.
In the example above, the value of my services, if we succeed and obtain the court order, could be measured at the value of the projected taxes saved – but I charge far less for this specific service, and I offer clients full refunds on all legal fees if the court ultimately denies granting our requested order.
Ask yourself: how can I leave my children the most?
BIO
Marc is a California trust attorney practicing in complex trust administration and tax-focused estate planning. Marc graduated from UC Irvine and Loyola Law School, then joined Gaw Van Male, LLP in Napa, California before moving back to Los Angeles to open CA Trust Law, APC.