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Bypass Trusts

What is a Bypass Trust?

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.

A bypass trust is a long-term planning device. If you leave property to someone in the form of a bypass trust, that property will not be subject to estate taxes when that person dies. (The property will still be taxed in your estate, however; to save tax in your own estate, other methods must be used.)

Protection from creditors and lawsuits: A bypass trust can protect asset. Since the trust was created and funded by the late husband, its provisions can protect the wife better from creditors and lawsuits. The protection gained this way varies from state to state.

Transfers two or more generations: Portability of the deceased husband’s $5.25 million applies only to the estate exclusion. A trust is required to allow the wife to benefit from the husband’s assets and still leave those assets to the grandchildren.

Preventing accidental inheritance: The wife’s remarriage changes her default inheritance while a trust keeps that inheritance clearly defined.

Professional management, spendthrift provisions, and avoiding probate: These can all be benefits of having a trust.

Growth outside of the estate: If a husband puts $5.25 million in a bypass trust it can grow to $22 million before the wife dies and still avoid estate taxes.

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 particularly useful for spouses who plan their estates together. By leaving property to each other in bypass trust form, they can guarantee that the property will only be taxed once between the two of them.

To effectively save taxes, a bypass trust must follow certain rules laid out by the IRS. Let’s suppose your will sets up a bypass trust for your husband, and you die first. In order to keep the trust from being subject to estate tax when your husband dies, your will must place the following conditions on the trust:

  1. You must limit your husband’s power to access the trust during his lifetime.

Your husband must not have an unrestricted right to withdraw principal. However, you can give him the right to withdraw principal to provide for his health, education, maintenance, or support, and you can also give him the right to withdraw up to $5,000 of principal per year for any purpose, or 5% of the total principal, whichever is greater.

You can also give him the right to all of the interest and dividends earned in the trust each year, and you can appoint him trustee. As trustee, he would have full discretion to decide whether principal is needed for his “maintenance” or “support.” Thus, this condition is ultimately quite flexible.

  1. You must limit your husband’s power to distribute trust assets upon his death.

Except as provided above, your husband cannot have the right to give the trust assets to himself, his creditors, his estate, or his estate’s creditors. You can, however, give him the right to name in his will specific persons who will succeed to the trust upon his death. For example, you could authorize him to leave the trust to any of your nieces and nephews, or to divide it as he pleases among your children. Alternately, you can specify who gets the trust next and leave him no discretion.

Although a bypass trust can be very flexible in practice, it is critical that the trust be drafted with absolute precision. The IRS has specified the words that may be used in a bypass trust, and if these words aren’t duplicated perfectly, the trust might not be excluded from tax in the second estate. Even the slightest drafting error can cost over a million dollars in taxes, so be sure your bypass trust is being drafted by an attorney who is knowledgeable about federal tax law.

But the advantages of a Bypass trust often are offset by the possibility of increased income tax. As the income accumulates in the trust, the trust itself is considered a separate taxpayer.

The trustee has to file an annual Form 1041 income tax return for taxable income generated by the trust’s assets that haven’t been distributed to the beneficiaries. It only takes about $12,000 worth of income to reach the top tax bracket. Most of the income accumulated in the trust, then, will be taxed at top trust tax rates. Upshot: a higher effective tax rate than for all but the wealthiest clients.

It’s worse if a pre-tax retirement account, such as a 401(k), is left to a bypass trust. That can result in a significant amount of ordinary income passing through to the trust, which can dampen the tax advantages of the retirement account.

Another problem: Assets in a bypass trust forfeit the potential for a second step-up in basis at the death of the second spouse. Most assets are eligible to receive a step-up in basis at death, but only if they are actually included in the individual’s estate at the time of death.

These concerns weren’t as much of an issue a couple of decades ago, when many bypass trusts were set up. As recently as 2001, the exemption to avoid the estate tax was just $675,000, so many estates were bumping up against that limit. Now that it’s $5.25 million, far fewer people need to transfer assets out of their estate to avoid being subject to that tax. The new rules on portability have also obviated much of the rationale behind many bypass trusts as well.

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