When the First Spouse Dies
The living trust is split into two parts, Trust A and Trust B, upon the death of the first spouse. These two parts are sometimes referred to as the "survivor's trust" and the "bypass trust."
Trust B holds the assets of the grantor of the trust who has died, which typically consists of both the decedent's separate property and one-half of his or her community property. If the couple's community property totals $1,500,000, Trust B would then contain $750,000. Trust B cannot contain more than the estate tax exemption, which is $1,000,000 to $3,500,000 depending upon the year of death. Since Trust B is subject to estate tax, as long as the amount placed in it is less than the exemptable amount, no federal estate tax is due.
Any remaining assets are placed in Trust A. Since Trust A is considered a marital deduction trust for the benefit of the surviving spouse, any assets put there are tax exempt. Trust A now becomes a revocable trust, and the survivor is wholly in control of its assets. He or she may remove all of its assets or income and control the trust however he or she wishes, including changing any of the trust's investments.
Dividing the Trust
Upon the first death, properly dividing the trust into the two sub-trusts is the primary concern. Since there are no probate or legal considerations for the assets of a living trust, the division is done without any court supervision. This division is accomplished by assessing the fair market value of all of the trust's assets as of the date of death. After doing so, the trustee can then decide which assets, and the value of the each of those assets, will be placed into Trust A and Trust B, respectively.
While the 2007 maximum estate tax exemption is $2,000,000 and is increasing through 2010, in 2011 it is scheduled to revert to its 2001 amount of just $1,000,000. Assuming that the husband and wife will survive past 2010, and the couple has less than $2,000,000 in community property, the assets of the original trust can be evenly split between Trust A and Trust B. If they had a greater amount, consideration must be paid to the potential future growth of the assets, and the highest "growth assets" (up to $1,000,000) should be placed into the "B trust" to maximize future estate tax benefits.
The trustee has full control over the division of the assets, based on their value at the time of death. As long as their home has a market value less of than the exemptable maximum in the year of death, it can be placed in Trust A, Trust B, or split between the two. With the high growth volatility of California real estate, for example, real property, or a substantial portion of it, is often placed in the "B trust" to avoid any potential estate tax liability for the appreciation accumulated between the deaths of the first spouse and the surviving spouse.
Upon the death of the husband or wife, the trustee is assigned in accordance with the trust agreement. Since the husband and wife are usually the initial trustees, the survivor is normally the sole trustee after the first one dies. All of the existing assets must be re-registered in the surviving spouse's name as the new sole trustee. The assets would now need to be registered, for example, as "Ann B. Smith, Trustee of the John A. Smith and Ann B. Smith Trust, dated September 1, 2003-Trust A" and "Ann B. Smith, Trustee of the John A. Smith and Ann B. Smith Trust, dated September 1, 2003-Trust B."
About Trust A
For the remainder of the surviving spouse's life, Trust A continues on as a revocable trust, wholly under the control of the surviving spouse. He or she can remove any assets, change Trust A's provisions, can receive as much or little of the income and principal of the trust, or cancel it outright. Since the survivor reports all income, capital gains or losses, and deductions on his or her personal tax return, no trust income tax filing is necessary.
About Trust B
The decedent's assets are contained in Trust B, which has now become an irrevocable trust. The survivor is typically this trust's sole trustee and can manage the assets, receive the income, and occasionally the principal amount of the trust's assets, but cannot cancel the trust or change either its provisions or its beneficiaries.
Unlike Trust A, Trust B must file an annual fiduciary income tax return, so its trustee must obtain a federal tax ID number. Any of the trust's earnings, be they interest, dividends, or net profits, are paid to the survivor, who is taxed for them while the trust, itself, is not. Capital gains are taxed to the trust, which usually retains them.
Although Trust B is not wholly controlled by the survivor, he or she can withdraw part of the principal if an emergency arises or if the "A trust" does not contain sufficient funds for the survivor's health, education, maintenance and support. The beneficiaries of Trust B's assets when it terminates may object if the funds are withdrawn and not used for these listed purposes, so the survivor may need to justify the need.
Operation of Trust A and Trust B
The two trusts that are created after the death of the first spouse usually have the surviving spouse as their sole trustee, who can sell or purchase assets for either trust, withdraw as much as needed from Trust A, and receive any or all income from Trust B. If a demonstrable need exists, the survivor can also take Trust B's principal. Trust B, which requires an annual income tax filing, must have some records kept, but none are legally required for Trust A.
Trust A does not require any accounting, but those set to receive the assets from Trust B when it terminates can demand an annual accounting of all receipts and disbursements from the "B trust".