Unfortunately, I have had some of my dear clients pass away since the beginning of the year. So I have been involved in several administrations of their living trusts. This leads me to think of some of the common and not so common issues that may arise during trust administration which may be useful to discuss.

When a couple has a joint living trust with a typical A-B arrangement, the joint trust usually holds all of the couple’s community property – what is “theirs”. When one of the spouses dies, what is “theirs” is separated into two shares, which may be thought of as “his” and “hers”. If all of the property in the joint living trust is community property, then “his” and “her” share of the community will be half of what was “theirs” before this death.

If “he” is the deceased spouse, then “his” share is distributed to the Bypass Trust and “her” share is distributed to the Survivor’s Trust. The amount of assets distributed to the Bypass Trust is usually dependent on the amount available to be sheltered from estate tax, sometimes called the applicable exclusion amount. This number is available to each spouse. One of the reasons a couple establishes a revocable living trust is to enable a couple to use each spouse’s applicable exclusion amount, thereby minimizing the potential estate tax liability. This technique maximizes the amount of assets which may pass to the children on the death of both of the spouses.

Just like the process when the joint revocable living trust is established, once the allocation agreement has been prepared and the assets to be transferred to the Bypass Trust are known, the Bypass Trust must be funded with those assets. This means that trust transfer deeds for real property assets and letters of instruction for bank and brokerage accounts must be delivered to the institution.

I am often asked this question from the surviving spouse who is confronted with allocating assets held in a joint living trust to two or three subtrusts. There seems to be some confusion as to how the Bypass Trust works for the surviving spouse as the beneficiary of such trust and as the Trustee of the Bypass Trust.

On the death of the first spouse, the terms of the Bypass Trust become irrevocable. The right of the surviving spouse to receive distributions of net income from the investments of the Bypass Trust and the right to receive distributions of principal from the Bypass Trust cannot be changed by the survivor once one spouse dies. Likewise, the surviving spouse cannot dictate where and in what manner the assets of the Bypass Trust pass upon his or her death. The terms cannot be changed by the surviving spouse. This is because the assets held by the Bypass Trust represent the share of the deceased spouse’s community and separate property (do you remember the schematic I drew at our initial meeting which shows this allocation of assets?). Since the property belonged to a person who is no longer living, the disposition of those assets cannot be changed because the deceased spouse is no longer able to consent to such change.

While the terms of the Bypass Trust cannot be changed by the surviving spouse, the survivor can, as Trustee of the Bypass Trust, direct and change the investment of the assets during the surviving spouse’s lifetime. As Trustee, the survivor has the power to act as stated in the trust instrument and the laws of the state where the trust is administered. This power may include the ability to buy and sell trust assets, to invest in all kinds of assets such as real property, intangible personal property such as stocks or bonds, or even tangible personal property such as artwork, collectibles and the like.

A piece of rental property is transferred to the Bypass Trust when the deceased spouse dies. The surviving spouse, as Trustee, can receive rental income from the property, but must place the rental income in an account titled in the name of the Bypass Trust. (By the way, the Bypass, as an irrevocable trust, has its own tax identification number because it is a separate taxpaying entity).

If the terms of the trust provide that the surviving spouse may receive net income annually, then the survivor transfers to the survivor’s trust, all of the net income from the rental property.

If the survivor wants to sell the rental property, he or she may do so, as Trustee of the Bypass Trust, but the proceeds from the sale remain in the Bypass Trust, either to purchase a new piece of rental property or to be invested in some other way.

Income taxes are paid at trust rates if the income remains in the Bypass Trust. If the income is transferred to the surviving spouse, he or she pays income tax on such income at his or her personal income tax rate. A separate income tax return is filed for the Bypass Trust each year after the deceased spouse dies.

The Internal Revenue Service provides that certain assets owned by a decedent do not receive a step-up in basis on the decedent’s death and therefore may accelerate an income tax liability after death. Income in respect of a decedent (IRD) is income earned by the deceased person which has not been reported on the decedent’s income tax form.

Assets which trigger IRD include IRAs, appreciated Savings Bonds, promissory notes, deferred compensation, accounts receivable, some dividends, some installment obligations, and commissions earned before death which were not paid until after death.

Trustees who are administering a trust upon the death of a Settlor must report IRD when it is actually received, which may occur during the process of funding subtrusts as provided in the trust agreement.

Also, Trustees may need to determine whether the IRD is characterized as ordinary income or as capital gains which affects the amount of income tax to be paid. The general rule is that whatever character the asset had when the decedent was alive, that is its character in the hands of the recipient.

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