Before this year, bypass trusts were necessary to preserve a deceased spouse’s federal estate tax exemption. This is no longer the case. Under the new estate tax rules, a deceased spouse’s estate tax exemption is portable.
But does this new law make bypass trusts obsolete? There are many instances when bypass trusts are beneficial despite portability.
Why Were Bypass Trusts Necessary?
Americans 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 $30 million, Husband can pass his half of the community estate to Wife tax free.
However, if the Wife receives the estate outright, the community assets would now be under her complete control. So when she dies, her estate would be worth $30 million. Without portability, Wife could pass up to the exemption amount tax free. But, her estate would be required to pay taxes on the excess.
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 held in trust.
The trust assets can be used to provide financial support to the surviving spouse for the rest of his or her life. However, the the surviving spouse would be treated as the owner of the trust assets for purposes of federal estate tax liability. When the surviving spouse dies, the assets could be passed to the trust’s remainder beneficiaries without estate tax.
The New Estate Tax Law
Federal estate tax rules allow the executor of a deceased spouse’s estate to transfer a deceased spouse’s unused tax exemption to his or her surviving spouse for use in addition to the surviving spouse’s estate tax exemption. This makes it possible to stack a deceased spouse’s unused estate tax exemption on top of the surviving spouse’s exemption. This can be done without the use of a bypass trust.
When to Use Bypass Trusts Despite Portability
Despite the fact that a deceased spouse’s exemption is now portable, there are reasons why you may want to include a bypass trust in your planning. These include:
- Protecting the assets you leave from creditors. Assets you leave to your heirs in a trust rather than outright can be sheltered from disgruntled spouses, creditors and others who may sue your heirs.
- Remarriage of the surviving spouse. A surviving spouse who remarries may forfeit the deceased spouse’s unused exemption amount if the new spouse dies first. 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.
- Your assets may appreciate. If you transfer assets in trust, any appreciation on those assets will not count as part of 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.
- You have grandchildren (or might someday). Portability does not apply to the $15 million 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.
- Your plan already includes a bypass trust. There are many benefits of having a bypass trust, and you shouldn’t automatically change your will if it includes one. However, it is important that you review your will to ensure the amount of assets headed for the trust still reflects your intentions.
- 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, you lose the exemption.
Portability allows married couples to transfer up to $30 million to their heirs without the use of a bypass trust. But the use of bypass trusts can still be beneficial in many situations. So it’s best to talk with your attorney about what is best for your individual circumstances.
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