Whether you are a business owner reflecting on your succession planning needs, or an individual who has amassed significant assets from sources other than a business, if you are married, a testamentary bypass trust should be considered in your estate planning process.
What is a Bypass Trust?
A bypass trust is a type of irrevocable trust and is most commonly used to pass assets from parents to children at the time of the second parent’s death. It is structured so the children will not have to pay estate taxes on those assets in excess of the current estate tax exclusion. A bypass trust is a testamentary trust, meaning that it is created upon the death of the first spouse as provided for within a joint trust created by both spouses.
One condition of a bypass trust is that the surviving spouse must have restricted rights to withdraw principal. The spouses who create the trust (the grantors, settlors, or trustors) specify how much money can be withdrawn from the bypass trust by the trustee on behalf of the surviving spouse and for what purpose withdrawals may be taken. During the marriage, the spouses also indicate in their living trust how the assets held in the testamentary bypass trust will be distributed to beneficiaries upon the death of the surviving spouse.
What are the Advantages of a Bypass Trust?
If a deceased spouse left all his/her assets directly to the surviving spouse through a living trust or will, the couple’s full wealth would be included in the surviving spouse’s estate, potentially subjecting at least a portion of the assets to unnecessary estate taxes for larger estates. In addition, if the deceased spouse’s estate passes directly to the surviving spouse or his/her trust, the surviving spouse could change or eliminate beneficiaries, successor trustees, dissipate the deceased spouse’s assets, or even revoke the trust altogether. There is also no protection against creditor claims once the deceased spouse’s assets have passed to the surviving spouse.
Therefore, the benefits of a testamentary bypass trust can be numerous, and typically include:
1) Protecting the deceased spouse’s testamentary intentions. Since a bypass trust becomes irrevocable upon the death of the first spouse to die, the surviving spouse can only reach the assets in limited circumstances which have been set out by the deceased spouse prior to death, while the balance of the assets held in the bypass trust are ultimately passed to the beneficiaries which have been designated by the deceased spouse.
2) Ensuring that the credit against estate tax of the deceased spouse is preserved. If the combined estates of both spouses are large enough, there will be federal estate tax to pay when the second spouse dies unless a testamentary bypass trust has been created.
3) The irrevocable nature of a bypass trust provides for some creditor protection. Because the surviving spouse does not own the assets held in the bypass trust, his/her creditors cannot typically reach those assets except to the extent they are actually distributed to the surviving spouse.
4) Protecting growth on the deceased spouse’s exclusion from estate tax. Since the estate tax exclusion is indexed for inflation and increases until the surviving spouse’s death, placing assets in a bypass trust can have the effect of protecting more of the deceased spouse’s assets from estate tax.
What are the Disadvantages of a Bypass Trust?
Despite the common advantages of bypass trusts, there are also certain disadvantages which must be weighed against the potential benefits. Since an additional trust is created at the time of the death of the first spouse to die, there are costs of administering two separate trusts which are not found with a single joint trust. In addition, assets held in a bypass trust do not typically receive a step-up in income tax basis at the time of the surviving spouse’s death. Instead, the income tax basis is stepped up on the death of the first spouse to pass, meaning that the ultimate beneficiaries may receive a lower tax basis on assets, which may result in more income tax due if they sell the assets.
Another potential disadvantage of a bypass trust is higher income tax on undistributed income held in the bypass trust. Any income which is earned on the assets held in the bypass trust and not distributed to beneficiaries is typically taxed at a compressed trust income tax brackets which subject undistributed income over a certain amount to the top marginal income tax rate of 39.6%.
Is a Testamentary Bypass Trust Right for Me?
Whether you would benefit from a bypass trust requires considerable thought and should include a consultation with an experienced estate planning attorney. Even if you already have a living trust, we typically recommend a review and reconsideration of existing estate plans every five years or upon the happening of major life changes, such as a death, divorce, remarriage, or when there are significant changes in the law.
If your family might benefit from a testamentary bypass trust, but you remain unsure, you can choose to delay the decision whether to create one or not by including a provision in your living will for a disclaimer trust. A disclaimer trust provides the surviving spouse with the option to create a bypass trust upon the death of the first spouse to die (if the couple’s current financial situation and legal environment make that most advantageous), or to accept a full transfer of the deceased spouse’s estate.
Whatever option you and your spouse choose, it is wise to have your estate planning documents prepared by an experienced estate planning lawyer. The IRS will not honor improperly created trusts for tax purposes, which could cost your heirs thousands if not hundreds of thousands of dollars in taxes. We’re here to educate and help you make these important decisions. Contact us today for a free evaluation or browse our website for more information.
 California has abolished estate taxes and follows the federal estate tax exclusion amounts, see https://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Estate-Tax
 Most bypass trusts provide for the health, maintenance and welfare of the surviving spouse to avoid a situation in which the surviving spouse may be left destitute because their own assets have been exhausted, so there usually remains some risk that the deceased spouse’s estate held in a bypass trust may be reduced to cover such expenses.