A bypass trust is an intricate trust arrangement used as a form of estate planning for wealthy married couples. The bypass trust is created upon the death of a spouse, transferring the contents of their half of community property out of the couple’s legal estate and into its own, separate legal entity.
The surviving spouse can draw income and other limited benefits from the bypass trust, but ultimately, the purpose of such a trust is to transfer the entire estate to beneficiaries (e.g., surviving children) with as little estate tax burden as possible.
In other words, a bypass trust literally bypasses the surviving spouse’s estate so that it can someday be handed over to the couple’s children or any other named beneficiaries.
Bypass trusts have fallen out of favor since major estate tax changes were implemented in the early 2000s. However, they still retain certain advantages, especially when it comes to protecting assets from creditors.
Additionally, some surviving spouses may have a bypass trust active, and they may wonder how to dissolve the trust to provide the least amount of tax burden possible to their surviving beneficiaries.
The concepts of bypass trusts can get confusing quickly, but the estate planning attorneys at New Mexico Financial & Family Law are prepared to help make perfect sense for your family. Learn more about trusts and other options available for maintaining your financial legacy during a confidential, no-obligation case review when you call us at 505-503-1637 or contact us online.
Bypass trusts came largely out of a period from the early 80s to the early 2000s where reducing estate taxes could prove exceptionally difficult for couples and their children who had earned past a certain means. By delaying the official transfer of assets to the estate of the spouse and the eventual beneficiaries, the beneficiaries could ultimately avoid paying hefty estate taxes on the assets and cash transferred to them.
However, incremental increases in the exemption equivalent amount from federal estate taxes meant that the bypass trust provided less and less of a benefit over time. The exemption equivalent increased steadily to $600,000 by the mid-90s, but then it increased rapidly to $5 million under the George W. Bush administration.
The passage of the Tax Cuts and Jobs Act (TCJA) in 2017 saw that amount increase to a staggering $13.61 million by 2024. Also, couples could claim the exemption individually, doubling that exemption to $27.2 million.
These increases are set to expire by 2025 when they will revert back to a single exemption per household of $7 million. Congress has the chance to act on the issue or let it expire, so it is currently unclear what the future will hold for this exemption.
What is known, currently, is that most couples will not exceed the $27.2 million exemption, especially since the exemption is portable, meaning it carries over to the other individual if one spouse does not use up their entire exemption. Because of this factor, far fewer households will be able to benefit from the bypass trust compared to the recent past.
Nevertheless, individuals engaging in estate planning may want to consider a bypass trust or similar arrangements if their goal is to reduce the tax burden for their ultimate beneficiaries. Refer to an attorney for specific guidance based on the actual current and projected values of your estate, as well as the specific outcomes you would like to plan for in the future.
Bypass trusts are commonly used as part of an “A/B Trust” framework. They are arranged prior to the death of either member of a couple but only become active and funded upon the death of one spouse.
At the time of their death, the spouse’s half of their community property will be deposited into the bypass trust — the “B” trust. The surviving spouse has all of their community property deposited into a separate trust: the survivor’s trust, or “A” trust.
Under the terms of most bypass trusts, the surviving spouse is allowed to draw income and obtain other, modest benefits from the trust’s contents and proceeds. Crucially, these expenses must be primarily for the purposes of “health, education, maintenance and support,” as opposed to personal enrichment or a lavish lifestyle.
Otherwise, the bypass benefits might not be obtainable.
Crucially, bypass trusts must also be irrevocable to obtain the estate tax avoidance benefits, so they cannot be altered by anyone, including the trustee unless all of the listed beneficiaries provide unanimous consent.
When bypass trusts were first gaining in popularity, the primary concern for wealthy couples was their inability to avoid estate taxes when passing holdings onto their beneficiaries. With massive changes taking place to U.S. estate tax policy over the past few decades, those concerns have now shifted primarily towards income taxes and capital gains taxes.
Put simply, trusts have to file a tax return, just like an individual would. The big problem here is that the tax brackets that apply to trusts are much less favorable than the brackets for individuals and households.
While an individual can avoid paying the top rate for taxes as long as their taxable income doesn’t reach above $415,05, trusts pay top taxes after earning just $12,400, annually! Additionally, trusts can end up paying the top rates (23.8%, in 2024) for capital gains and qualified dividends at this relatively low threshold, on top of a tax rate on ordinary income of over 40%.
Beneficiaries may be able to reduce this tax burden by claiming income from the trust directly on their own tax forms while using the distributable net income deduction. However, this same strategy may not work for capital gains.
The default mode under the Uniform Principal and Income Act (UPIA) is that capital gains in trusts are treated as adjustments to the principal. A trust can specifically state that capital gains will be treated as income instead, but this must be designated in advance of the trust’s funding.
Note, too, that the “step-up in basis” value of capital gains in trusts cannot be applied, which means that beneficiaries must claim the entire growth in value of the asset from the time it was originally purchased, as opposed to a “step-up in basis” value that can be applied from the date the asset was inherited.
All of these concerns can make a bypass trust more — not less — expensive for beneficiaries compared to a more simple trust or inheritance arrangement.
Simply put, many of the financial advantages of a bypass trust no longer apply in a world where households can exempt seven figures from their estate taxes. However, these exemptions are set to expire in the coming year.
While they are likely to be replaced with a similar arrangement — or, at very least, a “soft blow” decrease part-way towards the old exemption amounts — there are no guarantees as to what the exemption will be over the next 5–10 years.
Because of this concern, households with a net estate worth exceeding $5.5 million may want to consider the bypass trust as a still-viable option. They will want to follow the upcoming congressional sessions closely while staying in contact with an estate planning attorney, as well as their financial advisor.
Beyond tax savings benefits, though, there are still some advantages to the special legal arrangements created by a bypass trust. For one thing, the status of the trust as irrevocable and largely untouchable by the surviving spouse can be used to shield the assets held in trust from new creditor claims.
If, for example, the surviving spouse remarries and the new spouse has outstanding debts, the fact that the bypass trust is a separate legal entity means that creditors cannot access the contents of the trust to recover the value of unpaid debts.
Further, bypass trusts are excellent at preserving the wishes of an individual from the time of their death, even if the life situation of their spouse, children, or beneficiaries changes. Returning again to the example of a spouse remarrying, they may now have new step-children to add to their family.
The expectation may be for the remaining estate to be now divided evenly among all children, both the old and the new. A bypass trust, however, keeps the original arrangement intact, meaning that the original beneficiaries will have their access to income and asset transfers protected, no matter what happens.
Some individuals and families may be in a situation where a bypass trust made sense at the time it was created, but it now creates more limitations and financial disadvantages than it does benefits.
Bypass trusts create challenges in this situation because they are, by their very nature, irrevocable and unable to be significantly changed. The good news is that their value can be spent down to nearly zero, effectively distributing the contents of the trust to another individual or legal entity and causing the trust itself to be terminated.
Trustees have sole discretion when agreeing to such a distribution. As fiduciaries, they must feel that it is in the best interests of the intentions under which the trust was created.
All beneficiaries must also unanimously consent to the transfer so that the trustee can legally permit it.
Typically, the Bypass trust’s contents will be transferred in entirety to the Survivor’s trust. In this case, the probate court that handled the decedent’s estate should be given the opportunity to weigh in on the matter, as well.
Otherwise, one or more beneficiaries could later raise objections, potentially giving them the opportunity to pursue more assets in the estate by saying it goes against the decedent’s wishes.
A bypass trust is created and maintained as a separate legal entity. It receives its own taxpayer identification number and must file a 1040 income statement to the IRS annually.
Technically, the trust itself owns all assets contained therein, meaning the trustee is only able to make changes to the trust at their sole discretion, and only in order to uphold the value of the trust while honoring the original intentions under which it was created.
Because of this arrangement, trusts will have ongoing management and maintenance fees charged by the trustee. At the same time, the trustee has an obligation to the beneficiaries (and other designated individuals, such as the surviving spouse) to make timely and transparent ongoing reports regarding the contents of the trust, its status, any changes made, annual incomes paid out from it, and other vital information.
If the trustee is seen as violating their fiduciary duties, beneficiaries — as well as other named parties of interest, including a designated oversight body — can object and seek to have the trustee replaced.
No. A survivor’s trust can be revocable.
It is also seen as the property of the grantor, meaning the grantor must file statements on the trust on their own return. The grantor (aka the surviving spouse) is also able to make changes to the trust, at their sole discretion, although beneficiaries may be allowed to object to any changes or transfers, depending on the original language of the trust.
Whether trying to create a family trust, amend your will language before it goes into effect, or change or terminate an existing bypass trust, New Mexico Financial & Family Law is here to assist you.
Clearly, a bypass trust can quickly create a complicated situation for surviving spouses and other loved ones. Our goal is to help you untangle the not and understand all options available for moving forward.
We can advise you as to whether keeping a bypass trust active or creating a new one is in the best interests of your family and your financial goals. We can also assist with making plans to shift directions on your family’s previous strategy, given recent changes to finance and taxation laws.
Get started with your own journey towards a hopeful tomorrow when you call us at 505-503-1637 or contact us online to schedule a confidential case review with no obligation.
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