Planning for the future, especially when it comes to your
legacy, can feel overwhelming. With so many tools and strategies available,
it's important to understand which ones truly fit your goals. One such tool,
often discussed in estate and tax planning, is the Bypass Trust (also
known as a Credit Shelter Trust or A/B Trust).
In this article, we'll walk you through what a Bypass Trust
is, why it was created, how it works today, and whether it might still make
sense for your estate plan.
What Is a Bypass Trust?
A Bypass Trust is a legal structure designed to help married
couples reduce estate taxes and protect assets for their heirs. When one spouse
passes away, the couple's assets are typically split into two parts:
- Survivor's
Trust (Trust A) - This holds the surviving spouse's share and
remains flexible.
- Bypass Trust (Trust B) - This holds the deceased spouse's share and becomes irrevocable, meaning its terms can't be changed.
This setup ensures that the deceased spouse's assets are
preserved and managed according to their wishes, while also potentially
reducing estate taxes.
Why Were Bypass Trusts So Popular?
In the past, the primary reason for including Bypass Trust
provisions in a joint living trust was to avoid estate taxes. The estate tax
exemptions from 1997 to 2009 were much lower, ranging from $600,000 to $3.5
million. Basically, each person has an estate tax exemption, giving married
couples two exemptions. A Bypass Trust allowed couples to "capture"
the deceased spouse's estate tax exemption, which would otherwise be lost if
their share was simply gifted outright to the survivor's trust. Essentially, couples
used Bypass Trusts to make sure they didn't "lose" one spouse's exemption,
which could result in a higher tax bill for their heirs.
But things have changed. The federal estate tax exemption per
person has increased significantly over the years:
- 1997
- 2009: $ 600,000 - $3.5 million
- 2010:
$ 5 million
- 2018:
$11.18 million
- 2025:
$13.99 million
- 2026
and beyond: $15 million, thanks to the recently enacted One
Big Beautiful Bill Act
For most families, this means estate taxes are no longer a
major concern—at least at the federal level.
So, Do Bypass Trusts Still Matter?
Yes, depending on your situation. While they're no longer
essential for avoiding federal estate taxes for most people, Bypass Trusts
still offer several benefits:
- Tax
Efficiency for Larger Estates: For high-net-worth families, they help
preserve both spouses' exemptions, which in turn, preserves wealth for
future generations.
- Protection
Against Appreciation: Any appreciation in the Bypass Trust isn't taxed
in the surviving spouse's estate. Assets placed in a Bypass Trust are
"locked in" at their value at the first spouse's death. Any
subsequent growth or appreciation of these assets occurs outside the
surviving spouse's estate, thus avoiding estate taxes at the second death.
- Creditor
Protection: Assets in the trust are generally shielded from lawsuits,
creditors, or future spouses. This is particularly valuable in cases of
remarriage or blended families, where the deceased spouse may wish to
ensure their children receive a specific inheritance.
- Control
Over Inheritance: The irrevocable nature of the Bypass Trust ensures your
wishes are followed, even if your spouse remarries or changes their plans.
- State
Estate Tax Planning: Some states have "decoupled" from the
federal estate tax system, imposing their own estate or inheritance taxes
with much lower exemption amounts that are often not portable. A Bypass
Trust can be funded with the state exemption amount at the first death, allowing
each spouse to utilize their state exclusion and reduce the overall state
tax burden for the family.
- Generation-Skipping
Tax Benefits: The GST tax exemption, which prevents assets from being
taxed multiple times as they pass through generations, is not
portable. A Bypass Trust can be structured to utilize the deceased
spouse's GST exemption, ensuring these assets bypass the estates of
intermediate generations (e.g., children) and pass directly to "skip
persons" (e.g., grandchildren) without additional GST tax.
What Should You Watch Out For?
Bypass Trusts aren't perfect for everyone. Here are a few
things to consider:
- No
Second Step-Up in Basis: Assets in the trust don't get a second
step-up in value when the surviving spouse dies, which could mean more
capital gains taxes for your heirs.
- Irrevocability:
Once funded, the Bypass Trust's terms are generally fixed and cannot be
altered by the surviving spouse, which can reduce flexibility.
- Ongoing
Costs: These trusts require separate tax filings and administrative
work.
- Funding
Mistakes: If assets aren't properly allocated, the trust may not work
as intended. Failing to properly allocate assets between the A and B
trusts or neglecting to review and update trust provisions as tax laws
change can lead to unintended tax consequences.
- Portability
Issues: If the executor doesn't file the Form 706 to elect portability,
or in some cases, if the executor (who might be a stepchild in a blended
family) refuses to incur the expense of filing the Form 706 to elect
portability, the surviving family could lose valuable tax benefits.
A Flexible Alternative: The Disclaimer Trust
In some instances, a disclaimer trust provision
in a married couples' living trust might be a better fit. This provision allows
the deceased spouse's share to go to the survivor's trust by default. It still
gives the surviving spouse the option to disclaim some or all the deceased
spouse's share, which would then be allocated to a Bypass Trust or a Qualified
Terminable Interest Property (QTIP) trust. This offers flexibility without
forcing the creation of a Bypass Trust unless needed. This way, you're not locked
into a strategy that may not make sense years down the road.
Let's Talk About Your Legacy
As you can see, there are many choices, benefits and
pitfalls to navigate when creating a Bypass Trust. Please reach out to our Estate and Trust team
to help analyze your choices when passing wealth to your family or other
important people in your life.