Bypass Trust

A bypass trust is a trust created by the first spouse to die, funded with some or all of that spouse's own property, from which the surviving spouse may receive income and, on terms the instrument sets, principal, without the property becoming part of the surviving spouse's estate. Because the first spouse's exclusion covers the funding and the surviving spouse never acquires ownership, the trust and everything it earns pass to the children or other remainder beneficiaries at the second death with no further federal estate tax on that value.

The names are worth untangling, because there are three of them and none is official. "Bypass trust" describes what it does: the property bypasses the survivor's estate. "Credit shelter trust" describes what funds it: the credit that shelters the first spouse's exclusion amount. "A-B trust" describes the older two-share drafting pattern, in which the "A" share qualified for the marital deduction and the "B" share did not. Treasury's own portability regulations, when they need a phrase for the share that is not the marital share, call it a non-marital trust.

Why the property stays out of the survivor's estate. Two Internal Revenue Code sections do the work, and both work by absence. Section 2033 includes in a decedent's gross estate the value of property "to the extent of the interest therein of the decedent at the time of his death," and a beneficiary of someone else's trust holds no such interest in the trust's property. Section 2041 then includes property over which the decedent held a general power of appointment, defined at section 2041(b)(1) as a power exercisable in favor of the holder, the holder's estate, the holder's creditors or the creditors of the holder's estate. The exception at 2041(b)(1)(A) is the one bypass trusts are drafted around: a power to consume or invade property for the holder's own benefit "which is limited by an ascertainable standard relating to the health, education, support, or maintenance" of the holder is not a general power. So a surviving spouse can be a beneficiary, can receive all the income, can even serve as trustee with the power to distribute principal to herself, and still own nothing for estate tax purposes, provided the principal power is fenced by that standard.

What portability does not do, which is the whole modern case for the structure. A timely portability election preserves the first spouse's unused federal exclusion for the survivor, and for many couples that is simpler and cheaper than a trust. Four gaps remain:

First, there is no portability of the generation-skipping transfer tax exemption. It is allocated separately and it dies with the person who did not use it, so a couple who want a long-term trust for grandchildren cannot rely on portability to preserve the first spouse's GST exemption.

Second, portability is a federal mechanism only, and a federal election does nothing about a state estate tax. A state that imposes one sets its own exclusion and decides for itself whether any part of it may transfer to a surviving spouse, so in a state that has not provided for that, a trust is the only way to use the first spouse's state exclusion at all.

Third, section 2010(c)(4)(B)(i) measures the transferred amount by reference to the last deceased spouse, so a surviving spouse who remarries and is widowed again can lose the exclusion preserved from the first marriage. A funded trust cannot be displaced by a later marriage.

Fourth, and least about tax, portability leaves the property in the survivor's hands. The survivor can spend it, give it away, or leave it to someone else. A bypass trust settles who takes the remainder at the first death, which is frequently the actual reason a blended family uses one.

The price, stated plainly, because it is easy to leave out. Property that is not in the surviving spouse's gross estate is not revalued at the surviving spouse's death. The trust's assets took a new basis at the first death and keep it, however long the survivor lives and however much the trust grows. So the structure trades an estate tax saving on the growth for an income tax cost on the same growth, borne later by whoever sells. Which side of that trade wins depends on the size of the combined estate, on whether a state estate tax applies, and on whether the assets are ever sold at all.

The mechanics, from drafting through the second death.

1. The instrument divides the first spouse's property, usually by a formula clause rather than a fixed dollar amount, into a share funding the bypass trust and a share passing to the surviving spouse outright or in a marital trust.

2. The bypass share uses the first spouse's exclusion. It does not qualify for the marital deduction, and it is not meant to: it is taxable in principle and covered in practice by the deceased spouse's own exclusion.

3. The survivor benefits on the instrument's terms. All income is a common design, with principal available for health, education, support and maintenance so that the power stays outside section 2041(b)(1).

4. The trust grows outside the second estate. Nothing that happens to the value after the first death is measured again for estate tax.

5. At the survivor's death the remainder passes as the first spouse directed, with no estate tax on the trust and no new basis for the assets in it.

A hypothetical that shows both sides of the trade. Rosa dies leaving $5,000,000 to a bypass trust for her husband Tomas. The assets take a new basis of $5,000,000 at her death. Eighteen years later Tomas dies and the trust is worth $9,000,000.

On the estate tax side, the $4,000,000 of growth is not in his gross estate. Assume his estate is already large enough that every additional dollar would be taxed at the top federal rate of 40 percent. Keeping that growth out saves $1,600,000.

On the income tax side, the trust's basis is still $5,000,000, so the children inherit $4,000,000 of unrealized gain. If they sell and the gain is taxed at the top long-term rate of 20 percent plus the 3.8 percent net investment income tax, that is $952,000.

Net on these assumptions, the trust is ahead by $648,000. Change one input and the answer changes: if the combined estate had been comfortably below the exclusion, the estate tax saving would have been zero and the $952,000 would have been the whole story.

Pros

• Every dollar of growth after the first death is outside the surviving spouse's taxable estate, however long the survivor lives.
• It preserves the first spouse's generation-skipping exemption, which portability cannot do.
• In a state with its own estate tax that does not let an unused state exclusion transfer to a survivor, it is the only way to use the first spouse's state exclusion.
• The first spouse decides who takes the remainder, which a portability election does not do at all.
• It cannot be displaced by the survivor's remarriage, unlike a preserved federal exclusion.
• Creditor and remarriage protection for the survivor's benefit stream come with the trust form rather than having to be arranged separately.

Cons

• No second basis adjustment. The assets keep the basis they took at the first death, so the heirs inherit the built-in gain along with the property.
• It is a real trust: a trustee, a separate taxpayer identification number, annual fiduciary income tax returns, and compressed trust tax brackets on any income the trust retains.
• The surviving spouse does not own the property and cannot simply change course, which is the point of the structure and also its main practical complaint.
• An old formula clause written when exclusions were far smaller can now fund the entire estate into the trust and leave the survivor nothing outright.
• For a couple whose combined estate is well under the exclusion and who live in a state with no estate tax, it can add cost and rigidity for no tax benefit at all.