There are a number of good reasons to consider using a standard revocable trust, including minor children, spendthrift credit protection and to ensure funds go as you intended (i.e. a second marriage situation). However, a bypass trust, particularly for married couples with assets between $6 million and $10 million, may not always present the best scenario given the current applicable $5.34 million “exemption” from estate taxes for each individual and portability to the surviving spouse of a deceased spouse’s unused exemption. There are situations, particularly for married couples with adult children, where the best plan may be to rely on portability and a standard will rather than a bypass trust.
Portability effectively provides that the surviving spouse can carry over any portion of the applicable exemption amount into his or her estate that was not used by the spouse who was the first to die. However, portability is not automatic. The surviving spouse still has to file an estate tax return on the death of the first-to-die spouse even though no estate tax will be due.
What are the situations that make reliance on portability attractive?
If there is a high probability that adults will be the only beneficiaries of the estate with the consideration that such adults will have the maturity to handle large lump sum payouts.
When combined assets of a married couple is below $10 million.
Residency in Virginia or one of the other 30 states without an estate or inheritance tax.
What are the situations that may not make reliance solely on portability attractive?
Residency in the District of Columbia, Maryland or one of the states with a relatively high estate or inheritance tax structure or where there is no portability of the spouse’s exemption amount.
When minor children may be the beneficiaries of the estate. Without testamentary provisions for minors in a will or trust, a beneficiary will receive his or her full bequest upon reaching the age of 18.
When generation skipping taxes (GST) are a consideration. Married couples are not able to fully use the GST exemptions of both spouses if they rely solely on portability as the means to secure their respective estate tax “exemptions.”
Concerns about asset protection. By holding assets in trust, the trust can be used for the beneficiary's benefit while preventing the beneficiary's creditors from seizing the inheritance.
Younger couples where the spouse may remarry after the death of the first-to-die spouse.
Why does portability make a difference?
It effectively doubles the exemption amount for the combined assets of a marriage ($10.68 million). Prior to portability, estate planners would recommend establishing a bypass or credit shelter trust. A bypass or credit shelter trust effectively accomplishes the same result by taking advantage of the unlimited exemption amount afforded the transfer of assets from one spouse to another. The bypass trust establishes both a family trust and a marital trust within the bypass trust. The family trust includes the amount equal to the then-current federal exemption amount and is available for the support and maintenance of the entire family. The marital trust is funded with the remainder amount and reserved for the exclusive use of the surviving spouse. The family trust assets would, upon the death of the second spouse, “bypass” the second-to-die spouse’s estate and be fully exempted from the estate tax of either spouse’s estate.
Why could a bypass trust be less attractive?
Even with that advantage, a bypass trust may be less attractive in certain situations connected to the stepped-up basis of assets given the recent changes in capital gains taxes.
With portability, the cost basis of an asset is stepped-up to its value as of the date of death of the second-to-die spouse. In Virginia, if a beneficiary to a married couple’s estate valued under $10.68 million sells his or her inheritance immediately after the time of death of the second-to-die spouse, the beneficiary will not incur any federal or estate taxes. He or she is also unlikely to have any ordinary income or capital gains repercussions. However, a beneficiary of an asset in the family trust of a bypass trust will not receive such a stepped-up basis at the death of the second-to-die spouse. Because these assets are not in the estate of the second-to-die spouse, they are valued as of the date they were bought by the trust or transferred into the trust. Thereby, the beneficiary receiving assets from the family trust of a bypass trust is more likely to incur income or capital gains repercussions.
One possible solution for people with a bypass trust is for the second surviving spouse to withdraw funds from the trust to the extent permitted by the trust. Then the assets would be in the estate of the surviving spouse and could receive the stepped-up basis at the time of the second spouse's death.
With portability, the need for a bypass trust appears to be diminished for married couples with combined assets under the federal estate tax exemption amount, which is currently at $10.68 million in states (such as Virginia) which have no estate tax or inheritance tax.
Portability does not remove the need for a bypass or credit shelter trust altogether. However, given the recent changes in capital gains tax brackets and percentage tax rates (15 percent or 20 percent) and possible income tax consequences, the capitals gains tax has become a consideration in deciding to use a bypass trust. When factoring in the variables of the different estate, inheritance and income tax structures in each state and adding the 3.8 percent Obamacare tax on higher income individuals, the possibility exists that higher income beneficiaries may incur combined taxes near 40 percent in highly appreciated assets.
GST transfers further complicate the decision making process. If a deceased spouse leaves behind assets to the surviving spouse outright, relying totally on portability, then the deceased spouse’s estate could not take full advantage of both individual’s GST exemptions since portability does not apply to GST.
Use of a bypass trust in all family situations should not the norm, but rather, the efficacy of a bypass trust or a standard will-based estate plan should be determined by a case-by-case analysis.