Prior to the passage of the American Taxpayer Relief Act (ATRA) in 2012, the bypass trust was a tried-and-true method of sheltering assets from the estate tax. Without a bypass trust (and prior to ATRA), the action of bequeathing one’s entire estate to one’s spouse meant the deceased spouse’s exemption was lost—that is, when the second spouse died, the deceased spouse’s assets were fully subject to the estate tax.
The solution, prior to ATRA, was to put a portion of the deceased spouse’s assets in a bypass trust where they were not considered to be part of the estate of the second spouse. Therefore, properly established, the bypass trust allowed a surviving spouse to be an income beneficiary of funds that were deposited in the bypass trust—usually an amount equal to the federal estate tax exemption (as of 2014, $5.34 million). Upon the death of both spouses, the total tax exemption to the trustees was the combined exemption of the surviving spouse (also $5.34 million in 2014) and the unused exemption of the bypass trust –totaling up to $10.68 million in 2014.
However, ATRA made permanent a provision called portability. Under portability the surviving spouse is granted any unused exemption amount of the deceased spouse in addition to his or her own exemption—meaning that the couple effectively has a $10.68 million dollar tax exemption on their combined estates after both have passed on. Since the portability provision rendered the bypass trust obsolete for most people, it might seem like there would be no reason to set up a bypass trust at all…however, consider that there may be other features of the trust worth taking advantage of.
- Safety from creditors. Assets kept in a trust are considered off-limits to the creditors. This would mean both the creditors of the deceased spouse, as well as those of a new spouse should the survivor remarry.
- Remarriage exemption forfeiture. The portable remaining exemption of the deceased may no longer be allowed if the survivor remarries. In that case, the bypass trust once again works as a viable tax shelter as it did before ATRA.
- Appreciated assets. Since some estate assets may increase in value between the deaths of the first spouse and the second, the value may go over the amount allowed by the exemption. Keeping such assets in the bypass trust means they will not be subject to the estate tax regardless of appreciation. Additionally, since the amount of the unused exemption for the deceased is not adjusted for inflation after the year they passed, the bypass trust represents a good place for appreciating assets to be separate from the exemption.
- Unwanted beneficiaries. You may have personal reasons for keeping some estate assets away from certain persons; a bypass trust is a place to maintain those assets.
- The generation-skipping tax. The GST is a tax with an exemption linked to the estate tax exemption, but is not considered portable. Therefore, a bypass trust may shelter assets from this particular tax.
- Convenience. Portability requires an estate tax return to be filed regardless of whether any money is owed; a bypass trust may avoid this filing requirement.