By Kirk R. Wilson, J.D., LL.M.

The use of a “bypass trust” to allow one spouse’s estate tax exemption to be sheltered in a trust for the lifetime benefit of a surviving spouse and then to have the trust assets pass free of estate tax to the next generation has been a fixture of estate planning for years. Many couples have estate plans that mandate the establishment of such a trust at death. Now, however, as the result of a seismic shift in the federal tax structure, the bypass trust is no longer necessarily the best planning option.
This tax shift includes a new “permanent” estate, gift and generation-skipping transfer tax exemption of $5 million indexed for inflation (this year it is $5,340,000), increased income tax rates (including a new 3.8% Medicare investment surtax) that are now on parity with the top estate tax rate (40%), and a new estate tax option for married couples known as “portability of exemption”. Portability allows a surviving spouse to have the deceased spouse’s unused estate tax exemption added (“ported”) to the survivor’s exemption, essentially giving the surviving spouse a double exemption (which in 2014 could be as high as $10,680,000).
In many cases, this new paradigm can make the use of a traditional bypass trust to capture and preserve the first spouse’s estate tax exemption a less desirable option than it was in prior years, particularly for estates of less than $10.6 million. This is because assets in the bypass trust that have appreciated after the first spouse’s death will not receive a stepped-up income tax basis at the surviving spouse’s death. This will create a taxable capital gain that could have been avoided by use of the new portability option.
Many couples have estate plans that require the funding of a bypass trust at the first spouse’s death. While this was good planning a few years ago, if the planning goal is to reduce not only the estate tax but the income tax cost of transferring a couple’s estate to their heirs, this may no longer be the optimal plan.
One option for estates below the estate tax exemption amount would be to have spouses leave their estates outright to the surviving spouse. This would permit the surviving spouse to elect portability, and the survivor would have free use of the deceased spouse’s assets. On the other hand, having a trust gives each spouse the assurance that, if they are the first to pass away, their estate will provide for the surviving spouse for life and then pass to their children or other heirs. If a spouse simply leaves his or her estate outright to the surviving spouse, that spouse is trusting the surviving spouse not to change the estate plan over time. For example, if the survivor were to remarry and want to provide for the new spouse ahead of their children. A trust protects the interests of the children or other heirs.
A better plan might be to have the first spouse’s estate fund a marital trust and to give the surviving spouse the option to make a tax election (called a “QTIP“ election) in order to qualify that trust (or part of it) for the estate tax marital deduction. If that election is made, then none of the deceased spouse’s estate tax exemption would be applied to that trust. Instead the survivor could take advantage of the new portability of exemption by filing a simplified estate tax return in order to have the deceased spouse’s estate tax exemption added to the survivor’s exemption.
By electing portability, the assets in the marital trust would receive a stepped-up income tax basis at the time of the survivor’s death, thereby eliminating any potential capital gain tax on the subsequent sale of low basis assets held by that trust. If the QTIP election is not made, the marital trust would become a “bypass trust” that would capture and preserve the deceased spouse’s estate tax exemption. In other words, the survivor would have the ability to decide which option makes the most sense for estate and income tax purposes based on the size of the estate and the state of the tax law at that time.
In either case, the deceased spouse’s estate would be held in a trust, managed by the surviving spouse, providing for the survivor for life, and then the trust assets would be distributed to the next generation pursuant to the instructions contained in the will or trust agreement.
There are still some advantages to a traditional bypass trust. The entire bypass trust is exempt from estate tax on the second spouse’s death even if the assets have appreciated substantially, whereas with portability, the first spouse’s unused estate tax exemption (that is added to the survivor’s exemption) is a fixed amount that is not adjusted for inflation. So for estates over $10.6 million, a bypass trust can be more beneficial. Also, if the surviving spouse remarries and then outlives the new spouse, portability requires the surviving spouse to use the second spouse’s estate tax exemption, instead of the first spouse’s exemption, even if the second spouse’s exemption is less than the first spouse’s. With a bypass trust, the surviving spouse can actually get the benefit of both deceased spouses’ exemptions.
Finally, portability transfers the first spouse’s unused estate tax exemption to the surviving spouse, but not the first spouse’s generation-skipping transfer (“GST”) tax exemption. The GST tax is a wealth transfer tax in addition to the estate tax which taxes transfers that skip a generation, e.g. from grandparent directly to grandchild (since the government wants to get its tax cut at each generational level). Each person has a $5 million exemption (indexed for inflation) from both estate tax and GST tax.
So the first spouse’s GST exemption is lost if either a bypass trust is not created, or a QTIP Trust is not funded (and a “reverse QTIP election” made to treat the trust assets as passing from the deceased spouse for GST purposes). This becomes important if, after both spouses have passed away, lifetime trusts for children are set up that eventually pass to grandchildren. In that case, if the couple’s estate exceeds $5.3 million (i.e., one spouse’s tax exemption) either a bypass trust or a QTIP Trust (with a reverse QTIP election) should be used to capture the first spouse’s GST exemption.
These tax laws and concepts are complicated and so this is not a do-it-yourself project, but requires the assistance of a knowledgeable estate planning attorney. However, it is important for couples to know that the estate tax landscape has changed and if they have estate plans that mandate the funding of a bypass trust, it is time to visit with their estate planning counsel to make sure they are using the best tax planning structure for their situation.
[The author is a Woodlands-based estate planning attorney at the firm of O’Donnell, Ferebee, Medley & Frazer, P.C. He is licensed to practice law in Texas and California, is a board-certified probate, estate planning and trust law specialist in California, and holds an advanced law degree (LL.M.) in taxation. He can be reached at (281)875-8200. The firm’s website is]

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