Bypass Trust

Bypass Trust

When an estate is large enough (or nearly large enough) to generate estate taxes at death or if the estate is likely to appreciate significantly over time, it may be wise to structure estate documents that ensure that each spouse can take advantage of the maximum exemption allowed from federal estate taxes. This is accomplished through a bypass trust (also known as a credit shelter trust, disclaimer trust, or asset protection trust) which allows married couples to double the amount that will pass to heirs, tax-free. We usually recommend a flexible type of bypass trust, which gives the surviving spouse the option of funding the trust, in whatever proportion he or she chooses, if it is necessary to save taxes.

To illustrate the benefit of the bypass trust, let’s assume a $5 million exemption and an estate large enough to fully utilize the bypass trust at the death of the first spouse. Property is simply transferred after the first spouse dies to the trust equal to the amount offset by the federal estate tax credit ($5 million in this illustration). The surviving spouse is permitted to receive all or any portion of the income produced by the trust. In addition, the trustee would have the power to invade the corpus of the trust (withdraw principal), should this be required to maintain the standard of living of the surviving spouse. At the death of the second spouse, all trust assets would pass to beneficiaries free from estate tax, as they are not a part of the surviving spouse’s estate. Further, the estate of the surviving spouse would be entitled to its own estate tax credit, enabling $5 million to be distributed to heirs free of estate tax. Hence, by utilizing a bypass trust, both marriage partners can take advantage of the federal estate tax exemption of $5 million. By doing so, couples can protect $10 million from estate taxes (assuming a $5 million exemption amount).

The bypass trust can be very useful even for estates that are not large enough to cause them to be subject to federal estate tax. The bypass trust is perfect for the protection of assets from claims of creditors or a subsequent spouse of the survivor. Any assets transferred to the bypass trust are exempt from all claims of creditors of the survivor. Likewise, a subsequent spouse of the survivor has no right to make a claim against any of the assets of the bypass trust upon the death of the survivor or in a divorce. The bypass trust provides income to the survivor throughout his/her life, and can never be taken away from the survivor by any creditor or a subsequent spouse.

Under present legislation, the bypass trust is not necessary for married couples to each take advantage of their maximum estate tax exemption. Legislation enacted in December 2010, and reinstated in January 2013, provides for the portability of this exemption between spouses. Specifically, the legislation allows any unused exemption to be transferred to the surviving spouse, increasing the amount that the surviving spouse can ultimately distribute to heirs free of federal estate taxes. However, such legislation can always be changed, so individuals may want to include a bypass trust in estate documents to protect against the possibility of this portability provision being removed down the road, or to take advantage of the other benefits presented by these trusts.

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