Don't bypass the bypass trust
By Julius Giarmarco
Giarmarco, Mullins & Horton, P.C.
Prior to the Tax Relief Act of 2010, for a married couple to take full advantage of both spouses’ estate tax exemption, the predeceased spouse’s exemption had to be held in a bypass trust (also known as family trusts or credit shelter trusts), thus requiring some advanced planning.
Now, however, the executor of a deceased spouse's estate is allowed to transfer any unused exemption to the surviving spouse without creating a bypass trust. Portability applies for the gift tax exemption as well as the estate tax exemption. But the portability provision only applies to the last deceased spouse of the surviving spouse, thus eliminating serial marriages for the purpose of accumulating unused estate tax exemptions.
The portability option is only available if a deceased spouse's estate files an election on a timely filed estate tax return (Form 706) — even if a return is not otherwise required to be filed (because of the size of the estate).
Bypass trusts vs. portability
Despite the relative simplicity of just letting the surviving spouse use the predeceased spouse’s unused estate tax exemption in 2011 and 2012, there are several reasons for still using bypass trusts, including the following:
- The predeceased spouse’s unused exemption is not indexed for inflation.
- The first predeceased spouse’s unused exemption will be lost if the surviving spouse remarries and survives his/her next spouse.
- The appreciation in the assets in the bypass trust is removed from the surviving spouse’s estate.
- The assets in the bypass trust are protected from the surviving spouse’s creditors.
- Without a bypass trust, if the surviving spouse remarries and comingles his/her assets with the new spouse, there is the potential for disinheriting the children from the first marriage.
- The predeceased spouse (as opposed to the surviving spouse) controls the management and distribution of the assets in the bypass trust.
- There is no transfer to the surviving spouse of the predeceased spouse’s unused GST tax exemption.
- The portability provision sunsets on December 31, 2012.
A bypass trust does have some disadvantages. The surviving spouse’s access to the assets in the bypass trust, albeit broad, is restricted. And there is no stepped-up basis at the surviving spouse’s death for the assets in the bypass trust.
The bypass trust also adds complexity to the surviving spouse’s life in that separate records for the bypass trust must be maintained, and annual income tax returns (Form 1041) must be filed for the remainder of the surviving spouse’s lifetime. Finally, if the first spouse to die has little or no assets other than an IRA, then for income tax reasons it’s generally not advisable to use an IRA to fund a bypass trust (and forego a spousal rollover). Many couples with nontaxable estates, particularly those with children all from the same marriage, will prefer to simply leave their estate to the surviving spouse.
But for the reasons mentioned above, such couples may still want the ability to utilize a bypass trust. The solution could be a disclaimer trust.
With a disclaimer trust, a married person’s revocable living trust leaves his/her entire estate to the surviving spouse. The bypass trust is funded only if the surviving spouse then disclaims (refuses) part of the deceased spouse’s estate. This enables the surviving spouse to decide how much to keep outright (to be taxed at the second death) and the amount to be allocated to the bypass trust (which is shielded from estate tax at the second death).
For married couples who live in states that have their own estate tax, postponing the federal estate tax until the death of the surviving spouse (by using a bypass trust) could result in generating a state death tax at the first spouse’s death. This can occur if the state’s estate tax exemption is less than the federal estate tax exemption.
Another consideration is whether state law provides for an unlimited marital deduction against the state death tax. By using a disclaimer trust, the surviving spouse, upon the advice of counsel, will be able to determine whether it is more or less advantageous to fully fund the bypass trust and pay any state death tax.
In making an informed decision to disclaim and how much to disclaim, one must examine the size of the combined estate, the surviving spouse’s age and health (which impacts the spouse’s needs for funds), whether minor children will be beneficiaries of the bypass trust, the potential appreciation of the assets not disclaimed, the status of the estate tax exemption, and the applicability of a state death tax.
Finally, the actual disclaimer must meet certain legal and filing requirements and the surviving spouse must not accept any benefits from the assets disclaimed before filing the disclaimer.