And if so, who killed it?

What is a bypass trust?

It goes by many names, bypass trust, credit shelter trust, family trust, spousal lifetime access trust, B trust, etc.  But whatever the name, this type of trust generally provides that upon the death of a spouse, the deceased spouse’s property goes into the trust upon death for the benefit of the surviving spouse.  Although the rights of the surviving spouse depend greatly on the terms of each specific trust, the trust is available to help meet the needs of the spouse until his or her death, then are directed to other beneficiaries, most commonly the descendants of the deceased spouse.  These trusts can be created as a component of a revocable living trust or created through a will providing for such a trust to be established by an executor when a will is probated.  This type of trust is used as an option to simply gifting the deceased spouse’s estate outright to the surviving spouse as is commonly done in simple “ma and pa” or “sweetheart” wills (all to my spouse if he/she survives me, or to my children).

Why did bypass trusts become popular?

In a time long, long ago, if you are in your twenties, but not that long ago if you are over 60, the amount of a deceased person’s estate that could pass to heirs other than a surviving spouse before estate taxes kicked in was $600,000.  And when the tax did start to apply, the rates were pretty high, 40% and above.  Gifts to the surviving spouse, in most instances, were not subject to this tax due to something called the unlimited marital deduction.

That created a problem when the couple’s estate exceeded $600,000.  Let’s say Sam and Sally Sample had an estate worth $1,000,000 when Sam dies.  Assuming all their property was community property, Sam’s estate would be valued at $500,000, safely below the $600,000 limit even without the unlimited marital deduction.  But when Sally inherits Sam’s estate, then dies, she now has an estate of $1 million dollars.  Oops, her estate is over the tax-free threshold by $400,000.  At a 40% tax rate, her estate would owe $160,000 in estate taxes, as well as having the expense and burden of filing an estate tax return.

The bypass trust effectively allowed a couple to double the amount which would be unreached by an estate tax by not leaving Sam’s estate to Sally.  Instead, Sam would leave the estate to a trust for Sally’s care during her lifetime but would then go on to Sam and Sally’s children.  Assuming that the trust didn’t give too much control to Sally, the entire estate would pass estate tax-free at Sally’s death, because the assets in Sam’s trust wouldn’t be included in Sally’s estate for federal estate tax purposes.  Assuming Sam and Sally would otherwise prefer to take care of each other, then have their children inherit, using the bypass trust didn’t impose much of a burden to save that $160,000.  Sally could still be the trustee of the trust, have the right to the income, maybe even dip into the principal if needed, but still leave their two children an extra eighty thou.  Not bad!

Why has the bypass trust become less popular?

Let’s face it, having to retire upon a nest egg of only $1.2 million in today’s dollars doesn’t provide a lot security for those retiring today, given the longer life expectancies of Americans today and the relatively low interest and dividend rates that can be expected from the investable assets of an estate that size.  And of course, the estate includes the family home, which doesn’t generate income at all. Although it wasn’t quite as bad when the estate tax exemptions began to rise, everyone realized that the $600,000 was too low, and forced many Americans to start giving their estate to their children and grandchildren during their lifetimes to stay under the exemption.  It was “pick you poison,” jeopardize your retirement or risk a big tax bill.

The estate tax exemption then began to rise over a period of years.  About 5 years ago, the rate was set at $5 million per person, and indexed for inflation, which most thought would be about as permanent a solution as one could hope for from legislators.  However, in the early months of the Trump administration, the exemption almost doubled, and today stands at $11.4 million per person.  In this landscape, very few Americans have any concern with estate taxes.  So for most of us, the tax issues which caused bypass trusts to become popular simply ceased to exist.  Not only that, but it could also have adverse income tax consequences by losing a step up in tax basis on assets in the trust to the value at the date of death of the surviving spouse in some cases.

Are there still reasons to consider the use of a bypass trust?

Yes!  Although the primary reason that bypass trusts became popular has largely disappeared for all but a small percentage of even the top 1% of Americans as defined by net worth, there are still a lot of reasons to use a bypass trust in estate planning.  What might some of those reasons be?

  1.  Second marriage situations.  Husband has his kids, wife has hers.  Spouses want to provide for each other but are concerned about the surviving spouse leaving all the inheritance to the surviving spouse’s children, and none to the children of the first spouse to die.  Using a bypass trust allows the surviving spouse to still use the income to live on but can prevent the surviving spouse from disinheriting the other spouse’s children.
  2. Couples, married or unmarried, who don’t have any children.  The concerns here are pretty much the same as for second marriage situations.  The difference is that each wants their respective siblings, nieces or nephews to inherit after the death of the surviving spouse.
  3. Concerns over remarriage after the death of the first spouse.  Even if couples are in a first marriage, there may be concern that the surviving spouse may remarry and leave assets to the surviving spouse’s new spouse and/or the new spouse’s children rather than the children of the first marriage.  The bypass trust can be used to avoid this from happening, especially when coupled with a requirement for a prenuptial agreement by the parties to the second marriage.
  4. Liability concerns regarding the surviving spouse.  Perhaps one spouse has creditors or is prone to risk of lawsuits.  Physicians often have this concern over potential malpractice suits.  Bypass trusts can protect the surviving spouse from these types of claims, which is why these trusts are sometimes referred to as credit shelter trusts.
  5. Concerns that the surviving spouse lacks the willingness or ability to effectively manage a large sum of money.  Let’s face it, we all know those whose money always seems to “burn a hole in their pocket.”  Or maybe they don’t do well with investing.  Sometimes it is better to protect the surviving spouse from his or her own difficulties with managing an inheritance.

Verdict?

Although the bypass trust is less popular that it once was, it is far from dead.  Perhaps still around with only a slight limp?   It is still an important tool in the estate planner’s tool box and makes a lot of sense in the right situation.  So let’s not write it off just yet.

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