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Question:

Long ago, my parents created a family trust which required creating a survivor trust, credit shelter trust and QTIP trust upon the death of the first of them. One of them died. The credit shelter and QTIP trusts both have HEMS standards. The beneficiary (surviving parent) and remainder beneficiaries are all the same. The original trust allows merger for trusts with substantially similar purposes for the same beneficiaries. Even if all the trusts were merged, there would be no federal estate tax. Can they be merged, or does the HEMS standard prevent that?

Response:

As background, the purposed of this trust configuration is to give the trustee and executor of the estate the ability to make the most favorable tax choices after the death of the first spouse to pass away. Depending on the “facts on the ground” one, two or three trusts shares within the overall trust may be funded and those shares may end up in the surviving spouse’s taxable estate. If the couple lived in a state with its own estate tax, the trusts might even receive different tax treatment for federal and state purposes. Finally, as seems to be the case in your parents’ situation, choices that were made when the first spouse died may no longer make sense in the future if there’s been a change in the tax laws or other circumstances. The increase in the exemption amount for federal estate taxes from $1 million a couple of decades ago to over $12 million today, means that there are many instances where funds that needed to be sheltered from being in the surviving spouse’s estate when the first spouse died no longer need that protection. In fact, for capital gains tax reasons the family may be better off if the funds were in the surviving spouse’s taxable estate.

With that understanding, we can look at your situation. Unfortunately, I can’t provide a definitive answer because it depends on how the credit shelter trust was drafted and whether a QTIP election was actually taken on the estate tax return of the first parent to pass away. If so, the QTIP trust will be in your surviving parent’s taxable estate. In order for it to qualify as a QTIP, only the surviving parent may be a beneficiary, not anyone else. It’s possible that the surviving parent is also the only beneficiary of the credit shelter trust. If so, then the two trusts may be almost identical and would meet the first step that would allow merger. But the credit shelter trust may allow other beneficiaries. If that’s the case in your parents’ trust, they cannot be merged. In addition, if a QTIP election was taken, then I don’t think the two shares can be merged, because the QTIP trust is in the surviving parent’s taxable estate and the credit shelter is not. Here’s where the HEMS standard comes into play. If the credit shelter trust were completely discretionary, the trustee could distribute the property to the surviving parent which might have some beneficial capital gains tax results. Doing so would increase the size of the surviving parent’s taxable estate, which given the current high federal estate tax threshold probably has no estate tax consequences and would mean that all the property then would receive a step-up in basis upon the surviving parent’s death. But the HEMS standard bars such a distribution since it’s hard to see how that would be for the health, education, maintenance or support (the so-called “HEMS” standard) of the surviving parent.

As you can see, this is the kind of question that only a tax lawyer can love. And my response doesn’t even include a consideration of the survivor’s trust since you didn’t mention it in your second sentence, so I assume it wasn’t funded. For a definitive answer, you’ll need to take the trust to a tax attorney who can look at the actual language of the trust and the estate tax return for the parent who passed away, as well as its holdings, to advise you on the best course of action. Or just go ahead and keep the trust shares separate despite the fact that that might mean a bigger administrative burden.

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