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Bypass Trusts and “Portability”

Before 2011, bypass trusts were necessary to preserve a deceased spouse’s federal estate tax exemption. Under the pre-2011 rules, a bypass trust was necessary any time that the combined estate of a husband and wife would exceed the estate tax exemption of one of them if their intent was that the first of them to pass away would leave all assets to the surviving spouse.  This is no longer the case. Starting in 2011, the estate tax exemption is portable, which means that a spouse can leave their unused estate tax exemption to their surviving spouse at death, thus allowing a couple to accumulate assets with value of their combined estate tax exemptions without a bypass trust through the use of portability.

But even with portability, bypass trusts are still used in many scenarios.

Example of Why Bypass Trusts were Needed Prior to 2011

When a person dies, he or she can pass all property to a surviving spouse without incurring any estate tax liability. This is called the “unlimited marital deduction.” So if Husband and Wife have a community estate worth $10 million, Husband can pass his half of the community estate to Wife tax free at his passing.

However, if those assets are transferred outright to the Wife, the community assets would now be under her complete control. So when she dies, her estate would be worth $10 million. Without portability, on Wife’s passing her estate would include all $10 million of assets, but she would only be able to exclude from tax assets equal to her estate tax exemption ($5.45 million in 2016) but the assets above this amount would be subject to 40% estate tax.

How Do Bypass Trusts Work?

Bypass trusts work in the following way: Instead of passing all the estate to the surviving spouse, a portion of the estate up to the exemption amount is placed into a trust.  The trust assets can be used to provide the surviving spouse with income for the rest of his or her life as well as principal from the trust for his or her healthcare expenses, education expenses, and costs for his or her support and maintenance. However, the assets placed in the trust would not be treated as being owned by the surviving spouse for tax purposes, and would therefore not be included in his or her estate for purposes of federal estate tax liability. Upon the surviving spouse’s death, the assets could be passed to the trust’s beneficiaries without estate tax.

Portability

Post 2011, the executor of a deceased spouse’s estate can make an election (called a portability election) to transfer that deceased spouse’s unused estate tax exemption to his or her surviving spouse for use in addition to the surviving spouse’s estate tax exemption. This makes it possible for a deceased spouse’s unused estate tax exemption to be stacked on top of the surviving spouse’s exemption without the use of a bypass trust.  This is done by making a portability election on the deceased spouse’s Estate Tax Return (Form 706) due nine months following his or her passing.

Situations When Bypass Trusts Should Continue to be Used

Despite the fact that a deceased spouse’s exemption is now portable, there are still quite a few reasons why you may want to include a bypass trust in your planning. These include:

  1. Protecting assets from creditors. Assets that are left to your heirs in a trust rather than outright can be sheltered from creditors and others who may sue your heirs.
  2. Remarriage of the surviving spouse. A surviving spouse who remarries may forfeit the deceased spouse’s unused exemption amount. Additionally, the bypass trust allows you to control who gets the remaining assets upon the surviving spouse’s death. If you leave your assets outright to your surviving spouse, and he or she remarries and commingles those assets those of the new spouse, your children may not get the inheritance you would have intended.
  3. Your assets may appreciate. If your assets are left in trust, any appreciation on those assets will not be included in your surviving spouse’s estate. This reduces the possibility that your spouse’s estate will be worth more than the exemption amount when he or she dies.
  4. You have grandchildren (or might someday). Portability does not apply to the exemption from the generation skipping transfer tax. If you intend to include grandchildren as beneficiaries, you can make lifetime gifts to your grandchildren or apply part of your exemption to the bypass trust and include them as beneficiaries.
  5. Your plan already includes a bypass trust. There are many benefits of having a bypass trust, and you shouldn’t automatically change your estate plan if it includes one. However, it is important that you review your estate plan to ensure the amount of assets headed for the bypass trust still reflects your intentions.
  6. Avoiding administrative pitfalls. An executor of a deceased spouse’s estate must transfer the unused estate tax exemption to the surviving spouse by filing an estate tax return within 9 months of death, even if no estate tax is due. If the executor fails to do so, the unused exemption is lost.
  7. Portability could be repealed. Congress could repeal portability in the future.  If this were to happen, we could be in a situation similar to pre-2011 when a bypass trust was necessary to preserve the exemption of the first spouse to die.

Potential Drawbacks of Bypass Trusts

Bypass Trusts are not always a good planning tool.  Before planning with a Bypass Trust, a couple should consider the following factors:

  1. Creation and Administration Expenses.  Bypass Trusts have a significant cost to create, and an ongoing cost of administration.
  2. Separate Trust Income Tax Returns.  Bypass Trusts require separate trust tax returns (Federal Form 1041 and California Form 541) each year of existence.
  3. No Basis Step-Up on Survivor’s Passing.  Property held by a Bypass Trust does not receive an income tax basis step-up on the passing of the surviving spouse like assets in the surviving spouse’s estate will.  This could lead to a higher income tax liability to the beneficiaries.
  4. Loss of Control if Survivor is Trustee.  The surviving spouse losses some control over the assets in the Bypass Trust.  If he or she is the trustee, then he or she is only able to use the principal of the trust for his or her healthcare expenses, education expenses, and support and maintenance expenses.  This creates a loss of total control.
  5. Loss of Control if Someone Other than Survivor Trustee.  If a person or entity other than the surviving spouse is named as trustee, then the restrictions on distributions are less stringent, but the surviving spouse has to request distributions from the third party, also causing a loss of control.

By John K. Bishop  8/11/2016

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