For the past three decades, the Bypass Trust, which also goes by the names “AB Trust,” “Credit-Shelter Trust” and “Exemption Trust,” has been a standard estate planning tool for married couples.
Here’s how the Bypass Trust works: Upon the death of the first spouse, the Bypass Trust is funded with property having a value equal to the maximum amount that can be transferred to a non-spouse without estate taxes being imposed. The Bypass Trust is then managed to provide income for the surviving spouse for his or her lifetime, then passes to the children or other beneficiaries without counting as part of the surviving spouse’s estate. The name comes from the trust assets “bypassing” the taxable estate of the surviving spouse.
In the new estate tax provisions enacted by Congress last December, the limit on the amount that can be passed tax-free to a non-spouse was increased to $5 million. Suppose Harry and Sally, husband and wife, together have assets of $10 million. They arrange for a Bypass Trust to be created when the first spouse dies, either through wills or a living trust. At Sally’s death, the Bypass Trust is funded with $5 million, providing income to Harry for life with the remainder distributed to their children when Harry dies. Assuming the value of Harry’s estate remains level, on his death his exclusion covers his $5 million, while the assets in the Bypass Trust are not included in his taxable estate. Result: the children receive $10 million with zero estate tax.
A surprising feature of the two-year estate tax law that Congress passed in December is something commonly called “portability.” Previously, if Harry and Sally failed to set up and fund a Bypass Trust but simply left everything to one another, the opportunity to avoid estate taxes on the death of the second spouse would be lost. If Sally died leaving everything outright to Harry, Harry’s estate would then be $10 million. Because he’d only have a $5 million exclusion, the $5 million he received from Sally would be exposed to estate tax at a 35 percent rate at his death. Failure to use a Bypass Trust would generate $1.75 million in unnecessary estate taxes for their children. Ouch!
Portability avoids this harsh result. The new law creates something called the “deceased spouse’s unused exclusion amount,” or DSUEA. In our example, Harry could claim as DSUEA the full $5 million of Sally’s assets that he inherited directly, adding it to his own $5 million exclusion to avoid estate taxes altogether.
So we don’t need Bypass Trusts anymore, right? Not so fast. Here’s some food for thought.
First, DSUEA can only be claimed by filing an estate tax return. Otherwise, under the new law, there would be no requirement to file an estate tax return for an estate of less than the exclusion amount of $5 million, even if there’s a Bypass Trust involved. Estate tax returns are much more complex than income tax returns and, in my opinion, should only be prepared by knowledgeable attorneys or CPAs. Estate tax returns I’ve seen in recent years have typically cost from $3,000 to $5,000, although hopefully the IRS will come up with simpler (and less costly) forms for returns that are filed just to claim the DSUEA.
Second, suppose the surviving spouse remarries. The DSUEA only applies to the most recently deceased spouse. In our example, if Harry later marries Tiffany and she dies, leaving her $5 million to her own children thereby using her own exclusion, Harry’s kids are out of luck. Their father’s estate will have to pay that $1.75 million in taxes out of their inheritance.
How about Sally wanting to be sure that her children ultimately receive her half of the $10 million estate she and Harry accumulated before her death? After Sally dies, the Bypass Trust is irrevocable, and the children have legal rights to enforce its provisions and make sure it’s appropriately managed.
If Sally leaves everything to Harry, Harry could elect to change how the estate is divided among the children, or worse yet, eliminate some or all the children as beneficiaries. Or he could squander the entire $10 million in unwise business ventures. The children’s inheritance can even be lost through inattention if Harry remarries and dies without a will. At least with the Bypass Trust, half the couple’s assets can be protected from Harry’s foolishness and from his creditors.
Other advantages of the Bypass Trust over portability: the Bypass Trust can be funded with appreciating assets, while assets with stable value are left in the surviving spouse’s name; and ownership of assets can be divided between the Bypass Trust and the surviving spouse, creating the possibility of discounting the values of assets for estate tax purposes. These techniques that are used to increase the amount of assets going to the children without being subject to estate taxes aren’t available if one relies on portability.
Despite what’s being written in the popular media, there’s still an important place in many estate plans for Bypass Trusts. It would be unwise to simply rely on portability to avoid estate taxes. Although tax avoidance is important, it’s only one aspect of a properly developed estate plan. See a knowledgeable and experienced estate planning attorney before deciding what your plan should look like, and don’t be surprised when the planner recommends you use a Bypass Trust.
