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.

The Basics

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

Based on several recent private letter rulings, the IRS appears to have approved a technique that can solve the bypass funding dilemma.

Careful pre-planning is key. One spouse’s living trust gives the other spouse the right to exercise a general power of appointment over the trust assets to maximize the estate tax exemption. In this way, the poorer spouse can tap into the assets held in the wealthier spouse’s trust to reduce estate taxes.

The general power of appointment is a common estate planning tool used to provide flexibility to the estate plan. With it the grantor delegates to a second party the right to override certain disposition provisions in the trust and directs who will receive the trust principal.

A joint revocable trust used with a power of appointment may provide additional benefits in planning for bypass trusts. Joint revocable trusts are popular in the western United States as a way to deal with community property.

There are several key differences between community property and common law states (see sidebar for a list of community property states). Spouses in community property states are deemed to own half of all property acquired during the marriage with the exception of gifts and inheritances. In common law states spouses are assumed to own property separately if it is titled in only one name. Married couples in community property states receive a double increase in basis in community property, while the surviving spouse in a common law state receives only a half step up for jointly owned property.

Based on recent private letter rulings, it appears that the IRS may allow joint revocable trusts coupled with the general power of appointment technique to tap into a pool of assets owned by both spouses. For the couple who prefers to own assets jointly, this type of trust can provide an asset management tool and preserve marital accord.

It may be possible to structure the joint trust to obtain a double step up in basis for the trust’s assets at the death of the first spouse. In the private letter rulings dealing with joint revocable trusts, all the assets of the trust were included in the estate of the first to die. Normally, assets that are included in the deceased’s estate receive a step up in basis. The exceptions are IRD assets, such as IRAs, and assets that were received as a gift but bequeathed back to the donor within one year of the original gift. It was the IRS’ position that if the joint trust is revocable by either spouse, no gift occurs between spouses when property is retitled to the trust. The gift occurs when the general power of appointment is exercised, that is, at the death of the first to die. Thus the surviving spouse immediately receives back the property he or she gifted to the deceased spouse, and no step up in basis is applied.

If, instead, the spouses’ rights to the trusts are restricted, it may be possible to argue the exception does not apply. To achieve this, create a condition in the trust to complete the gift. One option is to require both spouses’ consents for any withdrawals from or changes to the trust. A less conservative solution is to use a QTIP trust to hold marital deduction assets. Remember: the trustee split the revocable trust assets into two pools. The bypass trust was funded with the optimum amount to eliminate estate taxes. The excess can also go to a special type of trust designed to benefit the living spouse. A QTIP trust qualifies for the marital deduction but limits the surviving spouse’s access to the principal. It is commonly used in situations involving second marriages to protect wealth for the children of a previous marriage.

Like any technique, the disadvantages must be weighed. You may find that some attorneys outside of community property states are unfamiliar with the use of a joint revocable trust. And for clients concerned with asset protection, a joint revocable trust does not provide the same protection that tenancy by the entireties does. Recharacterizing separate assets into marital property may expose them to divorce settlements. Finally, most of the tax basis for this technique is currently based on private letter rulings. Private letter rulings can only be relied on by the taxpayer requesting the guidance.

Guidance Is Key

As with all estate planning, the guidance of an experienced estate planning attorney is key. In states that have decoupled from federal estate taxes, the effect of state estate taxes must be considered, too. For a client with a sizable estate, it may be well worth the price of a private letter ruling and any legal fees to get an opinion from the IRS about the estate plan.


Tere D’Amato is director of advanced planning in Wealth Management at Commonwealth Financial Network. E-mail her at tdamato@commonwealth.com.