Certainly, none of your clients enjoys writing out a big check to the Internal Revenue Service this time of year. But there’s something even worse: Some clients are being asked to write a check to the IRS that’s bigger than it needed to be because they have been relying on a bypass trust.
While there are still advantages to bypass trusts, changes to the estate tax regulations have made much of the purpose for these vehicles obsolete. There are other options that can provide many of the same benefits of the bypass, without the income tax issues, as well as options for client to dispose of the assets in a bypass and minimize the tax costs.
A bypass trust is a type of irrevocable trust that is generally established to pay trust income and principal to the grantor’s spouse for the rest of that spouse’s life. The trust’s recipient is allowed some access to the assets in the trust — but not much.
The principal can be distributed for purposes of health, education, support or maintenance. And the grantor has the right to withdraw $5,000 or 5 percent of the principal, whichever is greater, every year.
The recipient is entitled to be the trustee, providing full discretion to decide whether principal is needed for support or maintenance. The recipient can also collect all of the interest and dividends earned in the trust each year.
There are several tax advantages to a bypass trust. When the grantor puts the assets into the trust for the benefit of the spouse, that transfer is tax-free. Those assets are also removed from the grantor’s estate, reducing the value of the estate and helping to avoid future estate taxes.