Bypass trusts after portability

Bypass trusts have long been used by married couples to reduce their tax liabilities, for both potential gift taxes as well as any possible reduction in taxable assets that transfer between spouses on the occasion of one of their deaths. But the new rules regarding portability have reduced some of the benefits of bypass trusts.

Before portability arrived in 2012, a deceased spouse who left all his assets to his spouse would get to transfer all that wealth to the surviving spouse’s estate. But at the time of her death, she would be able to protect their combined wealth from estate tax with only her own personal estate tax exclusion.

Generally, the bypass trust would be funded with as much of the deceased spouse’s property that fit under the estate tax exemption and pass tax-free to their heirs after the surviving spouse’s death.  The bypass trust was able to provide for the surviving spouse yet allow both spouses to use their exclusion to maximize their estate tax exemption for the next generation.

At that time, a bypass trust was one of the best ways to protect those assets. Now with portability, the surviving spouse gets the full estate tax exclusion for both spouses, so bypass trusts have become less necessary. But there are issues that people who have established those bypass trusts still need to deal with.

Too many of these trusts have been left unfunded, especially by people who now assume they have better ways to accomplish the same things in their estate plans. Earlier this year, at the 48^th annual Philip Heckerling Institute on Estate Planning, Martin Shenkman estimated that 40 percent of all practitioners have clients who have not funded bypass or other testamentary trusts.

If that’s the case, the first question is: Is it worth my time to keep this bypass trust operational?Even with portability there are still benefits that are particular to a bypass trust: Some of them to consider:

• A bypass offers protection from creditors. The surviving spouse is the ultimate beneficiary of the trust but does not actually own the assets in the bypass trust. That should offer a good deal of protection against lawsuits and other potential takings. If those assets simply pass into the surviving spouse’s estate via portability, that’s not the case.
• The first spouse’s desired terms can still obtain. With portability, when the assets pass to the surviving spouse’s estate, he or she is free to do whatever they wish with them. The bypass trust locks in the intentions of the first spouse to die, ensuring that the assets are distributed in the way the decedent wished. This is especially significant when the bypass trust might be set up with a second spouse. With portability, there are no such guarantees.
• It keeps the generation skipping tax exemption in play. If the combined amount that a couple might leave to skip-persons such as grandchildren is likely to be more than $5 million, a bypass trust can help ensure that the first spouse to die’s GST tax exemption can shield assets passing to grandchildren from this tax. Unlike the estate tax exemption, the GST tax exemption is not portable to a surviving spouse.
• Portability doesn’t apply to state estate taxes. If the client’s resident state has an estate tax, especially a sizable one, it might make sense to turn keep the bypass trust alive. There is no portability of exemptions against state estate tax.
• There are limits to the estate tax exemption. Truly sizable estates, with more than $10 million in them, can still be subject to estate taxes even after portability. For those clients, the bypass trust represents another weapon in what might need to be a varied arsenal.

So clients who have not funded that bypass trust should at least be presented with the options available to them and consider doing so. Proactive advisors will make sure they know all of these possibilities and advantages.