Historically, estate planning attorneys have used a bypass trust for married couples in order to prevent the estate of the surviving spouse from having to pay federal estate tax. However, the use of a bypass trust can have negative income tax consequences for your heirs.
Here is how the bypass trust model works: the amount of an estate that is not subject to federal estate taxation is known as the exemption; upon the first spouse’s death his or her federal estate tax exemption amount would fund a “B”, or bypass, trust; the balance of the first to die spouse’s assets would fund an “A”, or marital, trust. Although the assets of the B trust can be used for the surviving spouse’s benefit, there are restrictions on the surviving spouse’s access to the assets. Those restrictions mean that the trust B assets are not considered part of the surviving spouse’s estate upon his or her death. Therefore, the value of the surviving spouse’s estate and the amount of estate tax owed upon his or her death are reduced. The A trust holds property that is fully accessible to the surviving spouse during his or her life. The assets put in the A trust are not subject to estate taxes upon the first spouse’s death because of the unlimited marital deduction. However, whatever assets remain in the A trust at the time of the surviving spouse’s death are included in his or her estate.
Upon the death of the surviving spouse the assets in the A trust will receive a step-up in basis to the value of the assets at the date of the surviving spouse’s death. When an asset from that trust is sold after the surviving spouse dies there will be a capital gains tax savings for the heirs since only the gain above the stepped up basis amount will be taxed. However, the assets of the B trust will not receive a step-up in basis when the surviving spouse dies. Therefore, when a trust B asset is sold after the surviving spouse’s death the heirs will have to pay a higher capital gains tax than if the asset had passed to them directly from the surviving spouse or from the A trust, which does not have the restrictions that the B trust has.
In 2013 the federal estate and gift tax exemption amount was set at $5 million, with an annual inflation adjustment. For 2017 the exemption amount is $5.49 million. Accordingly, an individual can now leave up to $5.49 million to heirs and pay no federal estate tax. Moreover, under current law a surviving spouse can carry over the deceased spouse’s unused exemption. The personal representative of the deceased spouse’s estate must file an estate tax return to preserve that portability. This portability allows a married couple to currently shelter as much as $10.98 million from federal estate tax. That is, if the deceased spouse used none of his or her exemption and the surviving spouse preserves the portability of the unused exemption by filing the necessary return, the surviving spouse can have an estate worth up to $10.98 million and there will be no estate tax.
Given the high exemption amount and the portability of an unused exemption to a surviving spouse, the need for bypass trusts has been greatly diminished. (I also note that President-elect Trump has voiced a commitment to repealing the federal estate tax altogether.) For many couples it no longer makes sense to have a bypass trust. If the bypass trust can be avoided the couple’s estate plan will be simpler and the family will avoid the adverse income tax consequences caused by having property pass to a bypass trust. The bypass trust does still have relevance and utility for some couples and gifting must be factored into the estate planning process. That said, if your estate plan includes a bypass trust it could be a good time to consult with an estate planning attorney to determine if your estate plan needs to be updated.
Attorney, Davis & Mathis PC
Jamie’s areas of practice include real estate, probate, estate planning, municipal law, partnerships, corporate law and business formation. His real estate practice includes residential and commercial transactions, zoning and land use, easements, leases, subdivisions and foreclosures. He is a member of the Real Estate and Probate Sections of the Alaska Bar Association. For more information you may visit Davis & Mathis PC.