By Joseph Ferrucci
January 3, 2019

When estate taxes were high, married couples commonly used bypass trusts to reduce their estate tax exposure.  But due to the higher exemption levels, estate taxes have been effectively reduced or eliminated for most couples. So are bypass trusts still necessary?   

 

What is a bypass trust and how does it work?  

A bypass trust is a type of trust that comes into being after the death of the first spouse to die (the “deceased spouse”) and preserves the deceased spouse’s estate tax exemption.  Consider the following example.  A married couple, Anne and Bob, hired an attorney to do their estate planning in 2004, when the estate tax exemption was $1.5 million.  Anne and Bob were California residents and had a combined estate of $3.0 million.  All their assets were community property.  

Because each spouse is entitled to one exemption, Anne and Bob had a combined exemption of $3.0 million between them ($1.5 million x 2).  But if Bob passed away first and left the entire estate to Anne, his exemption would have been lost.  In the future, when Anne passed away, Anne would have ended up with a $3.0 million estate but only one exemption.  In 2004, at an exemption level of $1.5 million, this would have resulted in an estate tax of roughly $700,000.

Anne and Bob were advised by their attorney to set up a joint living trust, and the living trust included bypass trust provisions.  By using a bypass trust, Anne and Bob’s estate plan preserved the exemption of the deceased spouse.  Here’s how the bypass trust worked in their case:  

  • If Bob passed away, his half of the combined estate ($1.5 million) would be transferred into the bypass trust.   
  • Anne would be the trustee and sole beneficiary of the bypass trust.  She would have to keep the assets of the bypass trust separate from her other assets, but she could use the bypass trust for her health, education, maintenance, or support for the remainder of her life.   
  • Anne would keep the other half of the combined estate (the remaining $1.5 million) as her own. 
  • The bypass trust names remainder beneficiaries.  After Anne’s death, the remainder beneficiaries would receive whatever is left in the bypass trust.  Anne would not be able to amend or revoke the bypass trust during her lifetime.  

Upon Anne’s death, the bypass trust would not be subject to estate tax, because it would have already passed free of estate tax under Bob’s exemption at the time when Bob passed away.  Anne’s estate also would pass free of estate tax under her exemption.  Thus, the bypass trust reduced Anne and Bob’s estate tax to $0, saving their estate more than $700,000!   

 

Given the new, higher estate tax exemption, should we get rid of our bypass trust?  

Following the same example, fast forward to 2019.  It has been almost fifteen years since Anne and Bob set up their living trust, and they schedule a follow-up consultation with their estate planning attorney.   

Their attorney advises them that the estate tax exemption has changed dramatically since 2004.  The exemption is now $11.4 million per person, and Anne and Bob therefore have a combined exemption of $22.8 million. Anne and Bob’s combined estate has increased in value to $5.0 million, but that figure is still far below the new very high exemption level.   

Anne and Bob ask their attorney whether they should simplify their estate plan by getting rid of the bypass trust. Anne and Bob liked the estate tax savings that the bypass trust could provide, but the bypass trust seemed like it would be burdensome for the surviving spouse.   

Their attorney advises caution.  The current very high estate tax exemption levels are scheduled to sunset at the end of 2025.  At that time, the exemption will drop down to about half its current level, i.e., possibly around $6.0 million per person (or around $12.0 million for a married couple).  At that level, the exemption would still be enough to cover Anne and Bob’s estate, but there is still uncertainty about how and when the exemption will continue to change. The estate tax has become a political issue, and Congress may change the exemption levels again in the future.   

The attorney advises keeping the bypass trust, but making the bypass trust optional by adding “disclaimer” provisions.  Anne and Bob revise the estate plan to provide that if one passes away, all assets will go to the surviving spouse, but then the surviving spouse can choose to disclaim (i.e., refuse to receive) all or part of the deceased spouse’s assets, in which case those assets will be allocated to the bypass trust.  This approach preserves the benefits of the bypass trust, while keeping it flexible in case the estate tax changes again in the future. 

 

Are there any other benefits to having a bypass trust?  

Besides estate tax planning, couples can use bypass trusts as a way to provide for remainder beneficiaries.  As noted above, a bypass trust typically names remainder beneficiaries who will receive the remaining bypass trust assets after the death of the surviving spouse.  And because the bypass trust is not amendable or revocable, the surviving spouse cannot change those remainder beneficiaries.   

What if, for example, Anne and Bob each had children from prior marriages?  In that scenario, Anne and Bob each might want to allow the surviving spouse to use the combined estate for life, but then would want each of their children to receive an inheritance after the surviving spouse later passes away. The bypass trust would help achieve both of these competing goals.  

It would work as follows. If Bob died first, his half of the combined estate would be allocated to the bypass trust.  Anne would be able to use the bypass trust assets for her support during her lifetime.  At Anne’s subsequent death, the remaining assets of the bypass trust assets would be distributed to Bob’s children.  Anne’s children would receive Anne’s portion of the combined estate, which she held and owned outside the bypass trust after Bob’s death.   

Are there other options besides a bypass trust 

There are a few other tools that can provide some of the same benefits as a bypass trust.  

  • Portability.  Since 2011, if the proper tax election is made, a surviving spouse can “port over” the deceased spouse’s unused exemption amount (referred to as “portability”).  This achieves the same estate tax savings as a bypass trust, with less administrative burden for the surviving spouse over time.  Portability has some downsides, however.  Portability requires filing an estate tax return for the deceased spouse, when it may not otherwise have been necessary, and there are limitations on the use of deceased spouse’s unused exemption amount.  For example, it can be lost if the surviving spouse remarries and survives a subsequent spouse.  In addition, it does not extend to the generation skipping transfer (“GST”) tax, and some states have not extended it to state-level estate taxes.  
  • Marital Trust.  Instead of assets going to into a bypass trust after the death of the first spouse, the assets can go into a marital trust.  While the bypass trust passes assets under the estate tax exemption, the marital trust passes assets under the unlimited marital deduction (using a “QTIP” election), which means that the marital trust does not preserve the deceased spouse’s exemption amount. But a marital trust can be used in combination with portability to escape estate tax exposure. As an additional distinct tax advantage over the bypass trust, the assets of the marital trust will receive a second step-up in basis for purposes of future capital gains tax, on the death of the second spouse.  If a couple has more exposure to the capital gains tax than the estate tax, and they have different remainder beneficiaries, then the marital trust may be a good option.  A “reserve QTIP” election can be used to increase the available GST tax exemptions. Like the bypass trust, the marital trust is irrevocable and not amendable and will lock in future distributions to remainder beneficiaries.

There may be other tools available, depending on each couple’s unique circumstances. To determine what strategy is right for you, consult with a licensed, qualified estate planning attorney.  

 

DISCLAIMER: This article contains general information about legal topics. It is not, and is not intended to be, legal advice. Your use of information in this article does not make Joseph Ferrucci, Attorney at Law P.C., or any of its attorneys, your attorney and does not establish an attorney-client relationship. Every case must be analyzed independently, based on the specific and unique facts of the case. If you have questions about your particular case, consult with a licensed, qualified attorney. This article is intended for personal use only, and not for publication or distribution. 

© 2019 Joseph Ferrucci, Attorney at Law P.C.