A bypass trust, (also known as a spousal bypass trust, marital bypass trust, or family bypass trust) is commonly used to provide income to your spouse and other family members during the surviving spouse's lifetime. When structured properly, the assets held in a bypass trust, would not be included in your surviving spouse's taxable estate.
Rather, the trust assets would "bypass" your spouse's taxable estate at his or her death and pass estate-tax free to the beneficiaries of the trust. Before discussing the bypass trust in further detail, it is important to understand how tax policy affects the use of bypass trusts in estate planning.
The American Taxpayer Relief Act of 2012 (ATRA)
President Barak Obama signed the American Taxpayer Relief Act of 2012 (ATRA) into law on 1/2/2013 which made permanent an increased estate tax exemption amount and the ability of a husband and wife to benefit from each other's unused estate tax exemption amount ("portability"). ATRA locked in the $5 million (inflation adjusted) basic exclusion amount, called the "estate tax exemption amount."
The exemption amount has already increased to $5.43 million per person for 2015. Therefore, in 2015 a person who has made no prior taxable gifts can transfer up to $5.43 million at death without having to pay an estate tax. Further, ATRA also made permanent the practice of "portability," or allowing a husband and wife to use each other's unused estate tax exemption amounts without a bypass trust.
Prior to ATRA, a married couple's estate was exposed to a significant tax liability due to the "use it or lose it" proposition contained under the old estate tax law. Previously, the first spouse to die could transfer all of his or her property to the surviving spouse without incurring estate tax liability. Upon the death of the surviving spouse if all assets were to be transferred to the couple's children, 100% of the couple's property would be included in the surviving spouse's taxable estate, with the resulting estate tax liability offset by only the surviving spouse's own estate tax exemption amount.
Under the old law, bypass trusts were used to reduce tax liability. Bypass trusts in this capacity were funded with any amount in excess of the federal estate tax exemption trust to be distributed outright to the surviving spouse or used to fund a marital trust or Qualified Terminable Interest Property (QTIP) Trust.
After the passage of ATRA, some in the financial planning community, indicated that the necessity for married couples to include a bypass trust in their will has been eliminated. Under the new law, some couples may have been relieved of the need for a bypass trust.
Notwithstanding the changes implemented by ATRA, bypass trusts still have something to offer, particularly for investors with relatively large estates. For example, under the portability provision, growth in the assets are not excluded from the gross estate of the surviving spouse thus maxing out their estate tax exemption.
Also, it is important to note that when considering bypass trusts and portability strategy, taxable lifetime gifts will decrease your available estate tax exemption, thus decreasing the amount that can be put into a bypass trust, or the amount that your spouse can use under portability.
Bypass Trust Requirements
Bypass trusts follow the same elements found in other trust arrangements. Like other trusts, there is a grantor, trust assets, a trustee, a trust agreement and a beneficiary. Further bypass trusts can be established as a living trust or as a testamentary trust (a trust created in a will).
The primary difference when comparing a bypass trust with other types of trust is that a bypass trust is limited to a narrow purpose; that being the holding of a limited amount of funds equal to or less than the prevailing exemption amount in trust for your spouse. Whereas other trusts have a broader purpose, bypass trusts exist solely to reduce tax liability.
A bypass trust attorney can provide an evaluation as to whether this structure is an appropriate asset management vehicle. Counsel experienced in bypass trusts can also provide advice regarding the tax implications and financial impact of this form of trust.
If not structured properly, beneficiaries of a bypass trust can incur a significant tax liability. Therefore discussing these options with counsel experienced in bypass trusts is an important first step in deciding if a bypass trust is an appropriate estate planning tool.