With the passage of the American Taxpayer Relief Act of 2012 (“ATRA”), we are finally getting off the more than decade-long transfer tax rollercoaster where the amount one can transfer to heirs free of tax ranged from a low of $1M to a high of $5M and twice presented a potential drop back to old $1M levels. Now individuals can pass up to $5M (indexed for inflation) to heirs free of gift, estate or Generation-Skipping Transfer tax with excess transfers taxed at a rate of 40%. Another significant change is that a deceased spouse’s unused gift and estate tax exclusion is now “portable” to a surviving spouse with the filing of a timely estate tax return. While the new estate tax law is great news for married couples since they can transfer over $10M to heirs and more simply use their combined gift and estate tax exclusions, it might also mean that their bypass trust has become like outdated technology: still functional but not necessarily their best option.
A Closer Look at the Bypass Trust
Most married couples want the surviving spouse to be able to have access to the couple’s full wealth for their support during widowhood. Yet before portability, if a deceased spouse just left all his assets to his spouse the couple’s full wealth would be included in her estate but she would only have her own estate tax exclusion to shield their combined wealth from estate tax. The only way then for a married couple to both provide for a spouse and use both spouses’ estate tax exclusions was by funding a bypass trust at the first spouse to die’s death. The bypass trust would be funded with as much of the deceased spouse’s property that he could pass free of estate tax using his exclusion and pass tax-free to the couple’s heirs after the surviving spouse’s death. The bypass trust would thus provide for the survivor yet allow both spouses to use their exclusion to maximize what passed to heirs free of estate tax.
With the new portability rule you may not need the bypass trust to use both spouses’ exclusions but you might want to keep it given the following potential benefits of a bypass trust:
Protects the First Spouse To Die’s Testamentary Intentions.
If assets are left directly to a surviving spouse the surviving spouse might change the trust terms. The bypass trust is irrevocable on the first spouse’s death so it locks in the first spouse to die’s intentions which might be particularly important with second marriages or where there’s a concern that the survivor might change beneficiaries.
Provides the Surviving Spouse Some Creditor Protection.
The assets included in the bypass trust should provide the spouse with some level of creditor protection as the spouse would be a potential beneficiary of the trust but not actually own the assets in the bypass trust.
Protects Growth on the First Spouse To Die’s Property Excluded From Transfer Tax.
While the estate exclusion is indexed for inflation and increases until the surviving spouse’s death. any unused estate exclusion a surviving spouse takes from her deceased spouse is not inflation adjusted. Where there’s a chance that the total combined estate at the surviving spouse’s death might exceed $10M the couple may want to retain the bypass trust so that the appreciation on the first spouse to die’s property held in a bypass trust passes to heirs free of estate tax.
Ensures that the First Spouse To Die’s GST Tax Exemption Can Be Used to Exclude Property from GST Tax.
The generation-skipping transfer tax taxes assets that skip a generation such as a gift by a grandparent to a grandchild. If the combined amount you might leave to skip-persons such as grandchildren is likely to be more than $5M, you might want to consider retaining a bypass trust to ensure that the first spouse to die’s GST tax exemption can shield assets passing to grandchildren from this tax as the GST tax exemption is not portable to a surviving spouse.
Ensures that the First Spouse To Die’s Credit Against State Estate Tax Can Be Used.
If you don’t live in a state like California, Arizona or Nevada that abolished the state estate tax, you might want to use the bypass trust to be sure that each spouse is able to exempt as much of their estate as possible from state estate tax as state estate tax exemptions are generally not portable under current state laws.
If you don’t truly need the bypass trust you might want to get rid of it given the potential downsides to the bypass trust:
A Bypass Trust Requires More Significant Administration.
The need to divide assets at the first death and the associated costs with administering separate trusts for the surviving spouse’s lifetime, including the preparation of a separate income tax return/K-1s for beneficiaries is more costly than leaving all assets to a spouse and relying on portability to use both spouses’ exclusion.
Assets in a Bypass Trust Do Not Receive a Step Up In Income Tax Basis at the Surviving Spouse’s Death.
Assets transferred to a bypass trust at the first spouse’s death receive a step-up in income tax basis on the first spouse to die’s death but not again on the death of the surviving spouse. If assets are instead left to the surviving spouse relying on portability to use both spouse’s exclusion, the surviving spouse would receive an income tax basis step up on the first spouse to die’s assets at his death yet his assets would remain part of the surviving spouse’s estate where they could receive another step up in income tax basis at her later death. Without the bypass trust your heirs might receive a higher income tax basis in assets and pay less tax on a sale of assets after the surviving spouse’s death.
Assets in a Bypass Trust Might be Subject to Higher Income Tax.
A bypass trust’s undistributed income (not distributed out to beneficiaries) is taxed at compressed trust income tax brackets which subject any undistributed income over $12,150 (2014) to be subject to the top marginal income tax rate of 39.6% and potentially subject to the additional 3.8% Medicare surtax on net investment income.
Keep the Bypass Trust?
Many married couples will keep their existing bypass trust even if they don’t need it for tax purposes for the same reason they might keep an older model cell phone: it still works and provides some desired benefits. Others will consider losing the bypass trust if they anticipate having less than $10M to leave to heirs to save the surviving spouse the hassle of administering separate trusts after the first death and to potentially reduce the income tax heirs might face on the later sale of inherited assets given the potential for a step up in income tax basis at the survivor’s death. But even couples likely to leave less than $10M to heirs might keep the bypass trust if they (1) might leave more than $5M to a trust that would eventually pass to grandchildren (no portability of exemption against Generation-Skipping Transfer Tax) (2) don’t live in California, Arizona or Nevada or another state that has abolished the state estate tax and will have more assets than the state exemption (no portability of exemption against state estate tax) or (3) don’t want to create a new trust yet want to lock in the first spouse to die’s beneficiaries and provide creditor protection for a spouse.
We recommend you review your estate plan with your attorney every five years or upon any major life change. Even if the potential benefits associated with losing the bypass trust don’t spur you to take action today, a review of the bypass trust’s relevance is warranted the next time you review your estate plan and your attorney can recommend your best trust options, including:
- Keeping the bypass trust (AB Trust)
- Paring down to single trust structure (A Trust)
- Providing the survivor choice at the first death to keep a single trust structure or fund a bypass trust (Disclaimer Trust)
- Exchanging the bypass trust for a marital trust where a bypass trust isn’t needed for tax reasons but desirable to lock in the first spouse to die’s beneficiary plans and provide creditor protection to a spouse. A marital trust can provide these same non-tax benefits yet allow for a potential income tax-basis step up at the death of the surviving spouse (AC Trust).
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