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Residuary Trusts: Have They Outlived Their Usefulness?

Joe Marmorato, CPABy Joseph P. Marmorato, CPA

Years ago, bypass trusts were popular estate-planning vehicles that were primarily structured to use the estate tax exemption of both spouses. However, as tax laws have evolved and in view of the trusts’ initial intent, many residual trusts may no longer be necessary today. This is largely due to the increase in the federal estate tax exemption and the enactment of the portability election. These changes to tax law have made certain irrevocable trusts, such as residual trusts, less prevalent because many of the taxpayers who may have benefited no longer are subject to the estate tax.

Back in the 1990s, the federal estate tax exemption was about $600,000 per person. Today, the exemption stands at $12.06 million per person. (The exemption is set to revert to $5.490 million in 2026, and will be adjusted for inflation.) This substantial uptick increased the likelihood that the exemption will far exceed a spouse’s assets owned in his or her name, plus the value of the assets in a residuary trust. Further simplifying estate tax matters, Congress introduced the portability election back in 2013, which allows the transfer of any unused federal exemption between spouses. These changes have greatly mitigated the need for some of these trusts today.

CPA explaining trust options to elder couple.In fact, the issue may be more than becoming obsolete. A residual trust that was established years ago with the intention to minimize taxes could actually end up increasing taxes today. Many residual trusts set up years ago hold assets that have highly appreciated since the trust’s inception. The assets in the trust will pass to the beneficiaries at the carryover basis, and will not receive a step up in basis. This could leave beneficiaries with significant capital gain tax liabilities when the assets are disposed of at a later date.

If you believe it is unlikely that a surviving spouse will have an estate that exceeds the federal exemption, you may want to advise those clients to consider terminating their bypass trust and sending the assets back to the surviving spouse. If a trust is terminated, the beneficiaries have the final say as to where the assets will go. If the beneficiaries choose to have the assets brought back into the surviving spouse’s estate, the spouse may be able to escape estate tax due to the higher exemption, while the beneficiaries would receive a step up in basis on the assets when the surviving spouse passes away. However, the transfer of assets back to the surviving spouse could be considered a gift made by future beneficiaries, so gift tax consequences may need to be considered. If the surviving spouse is a Pennsylvania resident, it is likely these assets will be subject to the Pennsylvania inheritance tax when he or she passes away. Not all states have an inheritance tax though, so this may not be a factor that needs to be considered outside of Pennsylvania. In addition, it’s possible that the assets held in the trust were already included for Pennsylvania inheritance tax purposes when the grantor passed away in earlier years, so you could possibly be paying the inheritance taxes all over again.

A financial planner or CPA should work closely with the client and an estate attorney when evaluating whether or not to terminate a trust. The estate attorney can also help address the distinct laws that exist when it comes to terminating a trust, including potential gift tax considerations and other legal steps involved in terminating an irrevocable trust. While residuary trusts can be officially terminated with court approval, state statutes have been introduced over the years that allow for certain trusts to be terminated without court intervention. In Pennsylvania, a residual trust may be terminated through a settlement agreement drafted by an attorney, which includes the consent of the surviving spouse and any other beneficiaries of the trust.

Keeping all this in mind, it is important to not overlook the other benefits of preserving the trust for a client. These benefits may include personal family reasons, especially in the case of second marriages where the decedent is looking to avoid having any of the inheritance redirected to individuals other than those intended. These trusts may also allow for creditor protection, which may not be available if the assets were owned outright by the grantor.

The decision should come down to what is best for the beneficiaries. Weighing out the financial considerations as well as the personal reasons to maintain the trust can help determine what the best answer is for those involved.

Joseph P. Marmorato, CPA, is manager of tax planning with Domani Wealth in Lancaster, Pa. He can be reached at joe.marmorato@domaniwealth.com.

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