Updating the Bypass Trust

Is the bypass trust dead? Many people believed when the lifetime estate tax exemption rose to $5 million per person (indexed for inflation), the role of bypass trusts in most estates ended. Far from it. Under the current tax law the bypass trust can be turned from a powerful estate tax saver into a tool for optimizing income tax planning and meeting nontax goals.

Let’s first review how the bypass trust traditionally was used in estate plans and still can be used when the estate is valuable enough to be taxable.

The bypass trust (also called a credit shelter trust or A/B trust) was essential for married couples when the estate tax exemption was lower and most estates were at risk of incurring taxes. The will would direct to the bypass trust an amount of wealth equal to the estate tax exemption, and in the standard will the rest of the estate was given directly to the surviving spouse. The bypass trust stated that the surviving spouse would receive all the income from the trust each year and also could receive any principal necessary to maintain his or her standard of living. After the surviving spouse passed away, the children of the couple became beneficiaries of the trust.

The effect of this strategy was to avoid taxes on an amount of the estate of the first spouse to pass away equal to the estate tax exemption, so it passed to the children without being reduced by any estate taxes. Yet, the surviving spouse was provided for with the assets in the trust, though the value of the trust wasn’t included in the surviving spouse’s estate. The surviving spouse also could pass on an equal amount estate tax free using his or her own lifetime exemption.

With the exemption at $5.25 million per person for 2013 and $5,340,000 for 2014, only a few families need a bypass trust to help shield their estates from taxes. Families with estates below the exempt amount still should consider using a bypass trust to meet other non-estate tax goals and adapt the trust terms for today’s circumstances.

The primary goal of a bypass trust now probably should be to minimize the family’s income tax burden over the years. Start by giving the trustee more discretion regarding distributions from the trust and by naming the spouse and children and perhaps grandchildren as current beneficiaries instead of only the spouse.

Also, give the trustee more discretion regarding the investment strategy. Typical trust terms these days require the trustee to use modern portfolio theory or some similar form of diversification. The problem with this language is that under today’s tax code the location of assets matters considerably. It can mean the difference between paying ordinary income tax rates, long-term capital gains rates, or no tax.

Trusts reach the highest tax bracket and have surtaxes, such as the 3.8% net investment income tax, imposed at very low income levels. In addition, when assets are put in a trust they retain the tax basis the original owner had, and when distributed from the trust retain the tax basis the trust had. But assets held by the surviving spouse have their bases increased to current market value when they are bequeathed to the next owners, such as the children.

The trustee can take advantage of current income tax planning strategies and minimize income taxes on the family when given broader discretion regarding investments and distributions than is traditionally allowed.

The trustee can be allowed to consider family-wide asset allocation instead of only the trust’s investment portfolio when making investment and distribution decisions. The trustee also can be empowered to consider family-wide and long-term tax considerations as well.

For example, instead of distributing primarily investment income to the surviving spouse, the trust can distribute assets that have appreciated significantly. Removing them from the trust makes it possible for the surviving spouse to hold them for life and allow the heirs to increase the tax basis to their fair market value at the surviving spouse’s death. The heirs then can sell them and pay no capital gains taxes on all the appreciation.

You might want to put limits on this discretion, because when assets leave the trust there is the potential that they won’t find their way to the children. They might be redirected to charity or the family of a subsequent marriage. So, the trust agreement might give the trustee discretion to distribute to the surviving spouse only assets that have appreciated by, say, 20% or more or put a dollar limit on such distributions.

When the trustee has discretion to take income taxes into account in both portfolio decisions and distributions, he or she might be able to increase family after-tax wealth and income by avoiding the top tax bracket and the 3.8% investment income tax on trust income.  

You also should reconsider the powers of appointment clause of the trust. This clause allows a person, usually the surviving spouse, to decide who among the other named beneficiaries, usually the children and perhaps the grandchildren, will benefit from the remaining trust assets. The clause also might allow the spouse to decide if assets should be distributed outright to beneficiaries or retained in the trust for a period of time.

In the past, there was a bias to using a limited power of appointment. That kept trust assets from being included in the estate of the surviving spouse. But, because of the step-up in basis allowed beneficiaries who inherit and the high estate tax exemption, it might be beneficial to give the surviving spouse a general power of appointment over assets that have appreciated significantly. That puts the assets in the surviving spouse’s estate. That, in turn, allows the heirs to increase their basis in the inherited assets to current fair market value and avoid capital gains taxes when they sell the assets.

A final consideration is state taxes. These are a greater component of the overall tax bill than in the past, and in many states are likely to rise further. You might want to give the trustee or some other person the power to relocate the trust’s state of residence, particularly if the surviving spouse moves to a low income tax state but the trust was set up in a higher income tax state. A move would save money and be convenient.

A bypass trust also will continue to provide its traditional benefits. The surviving spouse has support and the remaining assets eventually go to your intended final beneficiaries. It also can provide professional management, creditor protection, and family-wide financial planning. With the recommended modifications, the bypass trust also helps reduce income taxes.

Bypass trusts should remain key elements of many estate plans. Their estate tax reduction benefits are necessary for fewer people, but they provide other valuable benefits when adapted for current law.