Bypass trusts, also known as credit-shelter trusts, have long been the method of choice for avoiding estate tax. In the last few years, however, the estate tax rules have changed significantly. In 2010, Congress tied the unified credit amount (aka the "estate tax deduction") to inflation ($5.34M in 2013, $5.43M in 2014). Before 2010, Congress had to vote to extend the estate tax exemption every year; now they must vote to stop it. Additionally, as of January 1, 2011, surviving spouses can elect to transfer their deceased spouses unused unified credit amount, known as portability. With the tying of the estate tax exemption to inflation and the advent of the portability rules for spouses, the use of bypass trusts for tax avoidance may now be obsolete.
Due to the recent changes in the tax law, use of bypass trusts may be harmful in many cases:
- Surviving spouses do not like bypass trusts. Bypass trusts must be maintained properly and require annual tax returns. Trust tax returns are not difficult, but they do make life more complicated for the surviving spouse.
- Trusts suffer compressed tax rates compared to personal income tax rates. For individuals, the top tax rate of 39.6% is reached for incomes greater than $406,751. For trusts, the maximum tax rate is reached at $12,500.
- When a person passes away, assets in the estate are treated as if they were purchased as of the date of death, called a "step-up in basis". A step-up in basis can result in a significant reduction in capital gains tax when the assets are later sold. If assets are passed directly to the surviving spouse outright, then the assets are given a 2 nd step up in basis. Property held in bypass trusts will receive the 1 st step-up in basis, but they do not benefit from a 2 nd step-up in basis upon the death of the surviving spouse. Thus, property held in a bypass trust may lose a large reduction in capital gains tax if the combined estate (husband and wife) is less than their combined unified credit amount, $10.68 Million in 2014.
Despite the disadvantages above, bypass trusts can still be useful in the following scenarios:
- Bypass trusts can solidify the wishes of the first spouse to die in regards to their estate. If all property is given to the surviving spouse outright, there is always a chance they can change their Wills after the first spouse passes. This is typically a big concern with "mixed families" involving spouses with kids from prior marriages. Bypass trusts can be used effectively to ensure that the kids of the first-to-die spouse are not disinherited by the surviving spouse.
- Bypass trusts can provide creditor protection to the surviving spouse. The assets in a bypass trust are protected from creditors, which may be a very important benefit if the surviving spouse has a risky occupation or is exposed to other significant risks.
- Assets transferred to a bypass trust are valued at the time of death. Therefore, if the assets will likely greatly appreciate in value after the first spouse's death (i.e. IPO for a startup, proven oil and mineral assets, etc.), the bypass trust can enable the growth in the value of those assets outside of the surviving spouse's estate. Although they do not receive the 2 nd step-up in basis after the surviving spouse's death, there is still a significant arbitrage opportunity if the estate is taxable due to the difference in the estate tax rate (40%) and the maximum capital gains rate (23.8%).
The changes in the tax law above have had tremendous impacts on our estate planning strategy. Whereas in the past we would always have utilized a bypass trust if the estate was greater than one of the spouse's unified credit amount, now we rarely automatically include a forced bypass trust in the estate plan. As an alternative, we frequently utilize "disclaimer bypass trusts" that give the surviving spouse the option of using the bypass trust if the circumstances call for it within 9 months of the deceased spouse.
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