Estate Planning Series: What is a Bypass Trust and is that the correct tool for me?

What is a Bypass Trust and Why Should I Use It? 

The Bypass Trust protects the surviving spouse's estate from being taxed on appreciation between the first and second death.  If there has been appreciation that leaves the survivor short of the federal estate tax threshold, we should consider using a trust and giving an independent person such as the trustee the right to grant the surviving spouse a general power of appointment over the assets in the bypass trust to force inclusion in the estate of the last spouse to die.  The result of that is a basis increase with no estate tax liability.  Growth in the assets in a bypass trust is excluded form the estate of the survivor.  In contract, growth is not excluded from the gross estate of the surviving spouse where assets are received outright, or if they pass to a QTIP Trust for the surviving spouse's benefit.  (Code Section 2033, 2044).  

How to Use Portability and the Generation Skipping Tax?  

There is no portability for the generation skipping tax.  So, a bypass trust at the first death passing to skip persons can secure the benefits of the first to pass generation skipping tax exclusion.  That means the survivor can use his or her own generation skipping tax exclusion.  

How is a Bypass Trust Beneficial for Blended Families? 

A bypass trust can avid unequal treatment that might otherwise occur in a blended family where at least one spouse has children by a prior marriage.  Substantial inequities can arise if this "credit shelter" approach is not used.  Often, there is a difference in approach between the executor or trustee and the surviving spouse's family.    Or, if assets are left outright to the surviving spouse, the spouse may give the assets to persons other than the spouse that died descendants.  If the survivor has children of their own, the often are the beneficiaries where the spouse is entirely free to act.  And, if the survivor remarries, there is the risk that the new spouse will benefit from the decedent spouse's property.  

What about a "QTIP" trust or Qualified Terminable Interest Trust? 

A "QTIP" trust is often used in order to take advantage of the marital deduction and still control the ultimate distribution of the assets at the death of the surviving spouse.  If a QTIP Trust is used, the surviving spouse may be able to take steps that would significantly disadvantage the decedent-spouse descendants.  For example, the surviving spouse could request and receive principal distributions from the trust, or make large lifetime gifts leaving no exclusion amount to apply against the marginal tax generated by the QTIP or could gift the income interest.  

For that reason, a premarital or post nuptial agreement can be used in which the parties agree that the surviving spouse will make certain the portability election is used.  That is because, otherwise, the surviving spouse could be entitled to a substantial estate reimbursement if there is a taxable estate which includes QTIP assets.  (Code Section 2519).   This may result in more power to the surviving spouse to the exclusion of the decedent's descendant, that was intended.  Trusts provide a variety of important benefits, including asset protection, management and restricting transfers of assets by the surviving spouse.  For that reason, whether and how the surviving spouse will manage the assets must be explicit in the trust agreement.    Similar benefits can also be utilized by using portability.  

The possible future incapacity of a spouse or descendant can be addressed through the trust.  And, special needs provisions can be included to guard against the trust assets being used for payments that could otherwise come from public assistance. 

What are the tax rules about this in 2020? 

In 2020, trusts with income in excess of $12,950.00 have that income taxed at the highest tax rates (37%) in 2020 and have the 3.8% net investment income tax apply over the $12,950.00 threshold--a threshold that is substantially below the threshold for individuals.  The 3.8% net investment income tax becomes payable when single filers exceed $200,000 of adjusted gross income, and married persons filing jointly exceed $250,000.   

In the next session, let's talk about why income tax planning will replace transfer tax planning as the primary focus.