Due to the federal estate tax exemption “portability” provision for married couples, some estate planners say that the bypass trust, previously a staple of estate planning, has been rendered obsolete. Portability was permanently extended by the American Taxpayer Relief Act of 2012 (ATRA).
Strategy: Don’t junk the bypass trust concept just yet. These arrangements still offer significant advantages.
A tale of two tax breaks: In the past, wealthy individuals often reduced their exposure to federal estate tax liability by combining two tax breaks.
- The unlimited marital deduction: As a general rule, any transfer between spouses, whether it is made during one’s lifetime or upon death, is completely exempt from federal estate and gift taxes.
- Estate tax exemption: Transfers to a nonspouse beneficiary may be sheltered by the federal estate tax exemption. Under ATRA, the exemption amount is $5 million adjusted for inflation ($5.34 million for 2014).
Therefore, by leaving your entire estate to your spouse, and vice versa, you wasted the exemption of the first spouse to die under the old rules that existed before the estate tax exemption portability deal. Upon the death of the surviving spouse, assets valued above the exemption amount were subject to the federal estate tax.
The bypass trust strategy was created to avoid this result. Typically, the trust was funded with assets equal to the federal estate tax exemption amount available at death. A surviving spouse could be an income beneficiary. As long as the trust was properly drafted, the value of the trust’s assets was included in the deceased spouse’s estate for federal estate tax purposes—where it could be sheltered by the deceased spouse’s federal estate tax exemption. The bypass trust’s assets were not included in the estate of the surviving spouse when he or she passed on.
However, the portability provision mitigates the tax reason for using a bypass trust. Under the portability provision—introduced by the 2010 Tax Relief Act and permanently extended by ATRA—the executor of the estate of the first spouse to die can elect to pass along any remaining federal estate tax exemption to the surviving spouse. That way, the surviving spouse can effectively have up to two full exemption amounts (up to $10.68 million for 2014) to shelter estate tax.
Nevertheless, a bypass trust may still be helpful for the following reasons.
- Assets of the trust are generally protected from creditors of the surviving spouse. Also, if the surviving spouse remarries, a spendthrift provision would protect the bypass trust assets from the new spouse’s creditors.
- Assets passing directly to a surviving spouse could appreciate in value or be subject to the estate tax upon the surviving spouse’s death. A bypass trust avoids this problem for appreciating assets held in the trust.
- The amount of the deceased spouse’s unused estate tax exemption is determined in the year of death. It isn’t adjusted for inflation. As a result, a bypass trust may be a good “parking spot” for assets likely to appreciate.
- With a bypass trust, you can protect against assets subsequently being directed to a person, or persons, whom you do not wish to benefit.
- The deceased spouse’s unused federal estate tax exemption passed along to the surviving spouse may be forfeited if the surviving spouse remarries.
- To elect portability, an estate tax return must be filed, even if no estate tax is due. This may not be required with a bypass trust.
- A bypass trust may be beneficial in avoiding or minimizing the generation-skipping tax (GST). Although a GST exemption is linked to the amount of the estate tax exemption, the GST exemption isn’t portable.
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