One of the tenets of estate planning for married couples with assets over $4 million is to optimize both spouses’ estate tax exemptions through the use of a bypass trust. But theory and practice often clash and, inevitably, the couples’ assets are titled incorrectly, the bypass trust is left under-funded, and tax credits are wasted. Or postmortem patches
increase the cost of settling the estate. New estate planning techniques may help your clients tackle these common problems.
Married U.S. citizens can transfer unlimited amounts of property to their spouses during their lives or at death. A taxpayer can also bequeath up to $2 million (in 2007) to non-spousal heirs without being subject to estate tax. Good estate planning recommends transferring the first $2 million of your assets to your children or other heirs with the balance going to your spouse. At the survivor’s death, he or she will also be given a $2million exemption from taxes. If proper planning is done, a couple can shelter $4 million from estate taxes.
Splitting the estate makes a lot of sense. By giving away rapidly appreciating assets to the children at the death of the first spouse, the estate of the surviving spouse may incur fewer estate taxes.
Enter the Bypass Trust
A bypass trust (sometimes called a credit shelter or family trust) is created when the first spouse dies, according to the terms of the deceased’s will or revocable trust. The executor or trustee decides which of the deceased’s assets will fund this new trust. A bypass trust gives the surviving spouse the security of knowing he or she can tap into an account, worth up to $2 million, with the balance going to the children. If the surviving spouse’s other assets are sufficient to support his or her standard of living, the bypass trust income can accumulate for the next generation. Thus, the bypass trust is not taxed at either spouse’s death.
On paper, this plan works. In reality, however, there are two problems:
In an ideal estate planning situation, each spouse owns $2 million in assets in his or her name or in a separate revocable trust. But, in many marriages, property is owned jointly with rights of survivorship and is not considered an asset of the probate estate or the revocable trust. The executor or trustee may find there are little or no assets to fund the bypass trust. This roadblock can be tackled through the spousal disclaimer of all or part of a particular asset. Disclaimers are fairly simple postmortem estate planning tools, but they must meet strict IRS requirements. The most important restrictions are that the person disclaiming cannot have accepted any benefit from the asset nor influence who will ultimately receive the property.
A more difficult problem to overcome is when one spouse owns the bulk of the couple’s assets. This is typically the case with business owners or when one spouse’s IRA represents the bulk of the couple’s wealth. Traditional wisdom has told us to transfer assets from the “rich” spouse to the “poorer” spouse when creating the estate plan; however, this is not often workable. For instance, in many states, a physician or other licensed professional cannot make a spouse a partner due to licensing restrictions. Or, due to malpractice liability concerns, the wealthier spouse does not want to transfer assets to the physician spouse. There is also the need to take care of a new spouse and preserving wealth for children from the first marriage.
Estate planners often find their recommendation to split the couple’s assets is not implemented and, if the poorer spouse dies first, the estate tax exemption was wasted.
A Simple Solution