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Broken Trust

Ken Begley

MORE THAN 40 YEARS ago, I was an agent for the Internal Revenue Service. During training, we learned about auditing individuals, corporations, subchapter S corporations, Schedule C businesses, partnerships and probably a few other areas that I’ve since forgotten. But there was one area we didn’t touch: trusts.

That puzzled me, so I asked the trainer why. His response: “You aren’t smart enough to audit trusts.” He told me that how trusts operate might change drastically based on slight differences in wording. Auditing trusts was left to lawyers who worked for the IRS.

Four decades later, I came to understand the trainer’s wisdom. I sat between my mother’s accountant and her lawyer, who were fighting over how a trust worked for tax purposes.

The irrevocable trust set up by my father’s lawyer not only didn’t save money, but also it endlessly complicated the finances of both my father’s estate and the rest of our family. The reason: all the tax law changes between when the trust was set up and when my father actually died.

To be fair, the lawyer’s actions in 1996 made sense at the time. At that juncture, anything over the $600,000 federal estate-tax exclusion was subject to tax rates ranging from 37% to 55%. But if you put the $600,000 in an irrevocable trust before you died and left it to grow, the $600,000 plus the subsequent growth would sidestep estate taxes when you died. There were other potential advantages to the trust, but this was the main selling point.

My dad died 23 years later, by which time the federal estate-tax exclusion had jumped to $11.4 million. My father’s estate and the trust were worth nowhere near that amount, so the trust no longer made sense. But the trust was irrevocable, so that was that. To add insult to injury, the stocks my dad owned outside the trust got a step-up in cost basis upon his death, but the trust’s assets didn’t.

Later, we hired a second lawyer and paid thousands to make changes to the trust. That allowed the trust’s assets to be included in my mother’s estate. This will ensure a step up in cost basis upon her death, thereby nixing the embedded capital-gains tax bill. But my mother couldn’t make this decision on her own. Instead, the change had to be approved by the trust’s beneficiaries, which included eight surviving children and 25 grandchildren.

What we were dealing with was what’s called a bypass trust. The notion: My mother could enjoy the dividends and interest kicked off by the trust, but the trust’s principal value would pass to her children and then to her grandchildren. This was all for less than $2 million in assets. Crazy, isn’t it?

Interests and dividends are about $50,000 to $60,000 a year. Do the math. With so many people involved, each beneficiary won’t get much income. In addition, either the trust or the individuals have to pay taxes on that income, and trusts are dunned on a far more punitive tax schedule than individuals.

One lawyer said he didn’t see an end to the trust. The trust was set up to flow through to the grandchildren, but he thought the intent was for the trust to eventually benefit the great grandchildren, of which there are currently 39.

This wouldn’t have meant much financially to those involved, given all the beneficiaries. But even ignoring that issue, this trust didn’t save our family money once you factored in taxes, lawyer’s fees and other expenses. In fact, it ended up costing us. There were other complications as well, but I’ll leave it there.

The moral of the story: Be careful making long-range financial decisions based on current tax law.  My father’s lawyer in 1996 was also a CPA. Everything he set up in 1996 made sense. Very little of it made sense when Dad died in 2019. Sometimes, the best plans in life are the simplest.

Ken Begley has worked for the IRS and as an accountant, a college director of student financial aid and a newspaper columnist, and he also spent 42 years on active and reserve service with the U.S. Navy and Army. Now retired, Ken likes to spend his time with his family, especially his grandchildren, and as a volunteer with Kentucky’s Marion County Veterans Honor Guard performing last rites at military funerals. Check out Ken’s earlier articles.

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