A once-popular estate planning tool included in many Last Wills and Revocable Trusts may now cost families more in taxes than it saves. Changes in the federal estate tax have made the "bypass trust" which was often included in those documents a less appealing option. If your estate plan includes a bypass trust, you should reconsider its necessity because it could result in more harm than good.
A bypass trust (also called an "A/B trust" or a "credit shelter trust") was designed to prevent the estate of the surviving spouse from having to pay estate tax on the assets held in the bypass trust. Under a bypass trust estate plan, the estate of the first spouse to die was split with the prevailing federal exemption amount used to fund the bypass trust and the balance of the estate, if any, distributed to the surviving spouse either outright or in trust. The purpose of the bypass trust was to “shelter” the estate tax exemption of the first spouse to pass away which would otherwise be lost if not used. While the terms of bypass trusts vary, they generally provide that the trust income will be paid to the surviving spouse and the trust principal will be available at the discretion of the trustee if needed by the surviving spouse. The assets of a bypass trust are generally not included in the surviving spouse's estate at his or her death and therefor would not be subject to federal estate tax.
In the past few years, federal estate tax rules have changed dramatically and now very few estates are subject to estate tax. The federal estate tax exemption is now "portable" between spouses. This means that if the first spouse to die does not use all of his or her $5.45 million exemption, the unused amount is available to the surviving spouse (provided a federal estate tax return is filed for the estate of the first spouse to die). Currently, the first $5.45 million (in 2016) of an estate is exempt from federal estate taxes, so theoretically a couple would have $10.90 million of exemption between them.
A bypass trust can actually cost more in capital gains taxes than it saves in estate taxes. When someone passes away, his or her personally owned assets receive a step-up in basis. When an asset is in a bypass trust, it generally does not receive a step-up in basis at the death of the surviving spouse because it is passing outside of the spouse's taxable estate. If the assets in the bypass trust are sold after the surviving spouse dies, the spouse's heirs will likely have to pay higher capital gains taxes than if the heirs had inherited the assets outright from the surviving spouse.
To find out if your estate plan contains a bypass trust or if you need a trust as part of your estate plan, please contact your attorney or a member of our Estate Planning team.