Bypass Trust

A Bypass Trust allows you to provide for your surviving spouse and leave assets to your children, without the burden of estate taxes.

Some Background
As of 2023, the federal estate tax exemption is $12,920,000. This means estates valued below that number are exempt from the federal estate tax.

The value of an estate is the fair market value of property owned at the time of the decedent’s death. This includes items such as cash, securities, real estate, and business interests. The total of those assets is the decedent’s Gross Estate. But the Gross Estate is not necessarily that which may be taxed; there are certain allowable deductions for items such as mortgages, debt, and property passing to a surviving spouse which may reduce the value of the Gross Estate to the Taxable Estate.

If the Taxable Estate is above $12.92 million, federal estate tax will be applied to the amount exceeding the threshold value at rates up to 40%. Bypass Trusts are often used by high-net-worth families seeking to eliminate the burden of estate taxes.

The Structure of a Bypass Trust
A Bypass Trust is created upon the death of the first spouse wherein the family trust is divided into two separate trusts. The first trust is the Marital Trust—often referred to as the “A Trust” or “Survivor’s Trust.”  The second trust is the Bypass Trust—called the “B Trust,” or “Decedent’s Trust” or “Credit Shelter Trust.” The Marital Trust is a revocable trust, whereas the Bypass Trust is an irrevocable trust. A revocable trust is one that may be amended any time before the death of the creator of the trust, while an irrevocable trust generally may be not changed without the permission of the beneficiary.

The Marital Trust contains assets that will pass directly to the surviving spouse. The Bypass Trust, on the other hand, contains assets that will pass to any person or entity, typically the settlor’s children. The surviving spouse typically receives income from the Bypass Trust during the surviving spouse’s lifetime.

How It Works
Imagine you are a California resident with assets of $20 million, and you decide to use a Bypass Trust to eliminate estate tax. Your family trust would provide that upon the first spouse’s death, the trust be divided into two trusts, the Bypass and Marital.

Upon the first spouse’s death, the Marital Trust and the Bypass Trust would be created, and the Bypass Trust would be funded with $12,920,000 million worth of assets in order to maximize the deceased spouse’s federal estate tax exemption. This trust would be set up naming your spouse as the lifetime income beneficiary, with the remainder going to your children upon the surviving spouse’s death. Since the Bypass Trust is funded with the maximum federal estate tax exemption amount, it would be exempt from federal estate tax.

The Marital Trust would then be funded with the remaining $7,080,000. The surviving spouse would be the sole lifetime beneficiary of the Marital Trust as well. The Marital Trust would not be subject to estate tax because it would be part of the unlimited marital deduction but is included in the surviving spouse’s gross estate upon the surviving spouse’s death.

A Few Notes on Taxes
It is important to note that depending on the type of assets placed into the Bypass Trust, the beneficiary children may incur a future tax liability. While all assets will receive a step up in basis to their fair market value as of the date of the decedent’s death, the assets in the Bypass Trust only receive a one-time step up in basis (as of the decedent’s date of death). However, the assets in the Marital Trust will receive a second step up in basis as of the date of the surviving spouse’s death.

For example, there could be real property in the Bypass Trust that appreciated in value between the first and second spouse’s death. The children, however, would receive the real property with a basis as of the date of death of the first spouse. Should they choose to sell the house, the children would incur a tax liability on the amount of appreciation above that basis. For more information on basis, click here.

A Note on Gifts
As of 2023, the annual gift exclusion amount is $17,000 per individual ($34,000 per married couple). If a gift, or aggregate of gifts, to any one person exceeds $17,000 in that calendar year, you must file a gift tax return (Form 709). Aside from the simple example of giving someone cash, a gift also includes selling property to someone for less than its fair market value or forgiving a debt owed to you. You will not have to pay taxes on the gift; however, your lifetime gifts will reduce the amount of your estate tax exemption. For example, if you make $1 million of taxable gifts during your lifetime, your estate tax exemption would be $11.92 million (2023).

A Note on State Exemptions
California does not have an estate tax at the state level, but some states do. Be sure to check the estate tax exemption for your state, as it may be a lower amount than the federal exemption. This could necessitate having less than $12.92 million in the bypass trust.

Estate Planning is paramount for the future of your loved ones. Need help with where to start? RJS LAW’s exceptional team of Estate Planning attorneys is here to assist. Please contact us at (619) 595-1655 or by filling out the contact form below.

Written by Charles Ecker

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