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Bypass Trust. The Simplest and Easiest Way to Reduce or Eliminate Estate Taxes

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How many years will it take your kids to save $100,000 after taxes? For those readers who are married and have an estate of $2 million or more, a bypass trust can save the ones you love at least $100,000 in estate taxes. Do I have your attention yet?

A bypass trust is sometimes known as a family trust or a credit shelter trust. When the first spouse of a married couple dies, he or she can pass all his or her assets to the surviving spouse free of estate taxes because of the marital deduction. But when the surviving spouse later passes on, his or her estate will now be much larger because of the assets inherited at the death of the first spouse to die.

Example 1: Oregon has a $1 million estate tax exemption. If Harry and Sally, who are married, each have $1 million in assets and Harry dies and gives all his assets to Sally, she will die with an estate of $2 million. She will have a $1 million exemption, and thus $1 million in assets will be subject to Oregon’s estate tax at the rate of 10 percent. Thus, Sally’s estate will end up paying a $100,000 Oregon estate tax.

If a bypass trust is utilized, that $100,000 in estate taxes can be saved! In Washington, where the estate exemption is $2 million, even more can be saved.

Example 2: If Harry and Sally, who are married, each have $1 million in assets and Harry dies and gives his $1 million to Sally in a bypass trust, when Sally later dies, the $1 million in the bypass trust is not included in her estate. She is treated as owning only the $1 million in assets that she owns outright. There is no tax at Sally’s death because the $1 million that Sally owns outright is fully sheltered by Oregon’s $1 million estate tax exemption.

Maximum flexibility can be built into a bypass trust. Here are the types of flexible provisions that a bypass trust for Sally might include:

  • Sally can be the trustee of the trust.
  • All income of the trust can be distributed to Sally or just as much as she needs for her health, education, maintenance, and support.
  • Trust principal can be distributed to Sally for her health, education, maintenance, and support.
  • Sally as trustee can distribute trust income or principal to children and grandchildren for their health, education, maintenance, and support.
  • Sally can be given the right to determine after Harry’s death who among her children and grandchildren will receive the assets in the bypass trust, and whether they are distributed to a child or grandchild outright or in trust.
  • If Harry’s Will or living trust provides for a disclaimer, Sally can make a decision up to nine months following Harry’s death whether to establish a bypass trust and what assets will pass to the bypass trust. But if she does transfer assets to the bypass trust using a disclaimer, Sally cannot have power described in the preceding bullet point to determine who receives trust assets following her death.

But wait, there’s more (without paying separate shipping and handling charges)! For federal estate tax purposes, the exemption is now set at $5.25 million, and for a couple, under new federal portability law, the unused $5.25 million exemption on the death of the first spouse will pass to the surviving spouse. Thus, without using a bypass trust in a state such as California, which does not have an estate tax, a married couple can ultimately pass $10.5 million to their children or others.

For couples with larger estates that might exceed the federal estate tax exemption of $5.25 million, a bypass trust can still save substantial estate taxes. For example, there can be additional savings by using a bypass trust in certain remarriage situations and when the assets substantially appreciate:

Example 3: Harry has a taxable estate of $5.25 million, as does Sally. Harry dies and passes his estate to Sally outright. Sally remarries, and her new husband predeceases her. As a result, she loses the "portable" $5.25 million federal exemption from Harry. She would die with a taxable estate of $10.5 million, and $5.25 million would be subject to an estate tax at the 40 percent rate, for a total federal estate tax of $2.1 million. Ouch! If Harry had given his $5.25 million to Sally in a bypass trust, the tax on Sally’s death would be zero, for a savings of $2.1 million.

Example 4: Harry has a taxable estate of $5.25 million, as does Sally. Harry dies and passes his estate to Sally outright. Harry’s estate owns stock in a great high-tech company that appreciates after his death by $5 million. Sally dies with a total estate of $15.5 million and because of portability has a combined estate tax exemption of $10.5 million. But the $5 million in appreciation is taxed at a rate of 40 percent, creating an estate tax of $2 million. If Harry had given his assets to Sally in a bypass trust, the entire value of the assets in the bypass trust, including the appreciation in those assets, would be excluded from Sally’s estate. Thus, when Sally died, the part of her estate subject to estate tax would be only $5.25 million (instead of $15.5 million), all of which would be sheltered from the federal estate tax by the estate tax exemption. The tax on Sally’s estate on her death would be zero, for a savings of $2 million.

The bypass trust is the most flexible and most often used tool in the estate planner’s arsenal. It has great flexibility. For couples in Oregon, the savings start at combined estates in excess of $1 million.

For Washington couples, the savings start at combined estates in excess of $2 million. The savings can be substantial. So is it worth it to use a bypass trust to save $100,000 after tax for your children? Absolutely.

Related Files: Estate Planning Advisor - Spring 2013