Q: Why do most financial planners and attorneys refrain from stressing the importance of creating a credit by-pass trust through a clients will when the federal estate tax is below $5,250,000?
A: A “credit by-pass trust” (also known as a “Bypass Trust” or “Exemption Trust”) is a type of trust utilized in Wills and Living Trusts of married clients. It preserves the federal estate tax exemption amount of the first spouse to die by placing such deceased spouse’s assets into an irrevocable trust without any estate tax. Had the deceased spouse instead bequeathed their estate outright to the surviving spouse, this would have resulted in the loss of the deceased spouse’s exemption amount and all of the estate included (and taxed) in the surviving spouse’s estate when they died. The Bypass Trust typically named the surviving spouse and descendants as beneficiaries of the trust being able to access both trust income and principal as needed. Upon the surviving spouse’s death, the Bypass Trust is not included in the surviving spouse’s estate and bypasses the estate tax passing free of estate tax (including its growth) to the next generation.
In the past, this was a common strategy for married clients when the federal estate tax exemption was only $600,000; however, in Year 2014, the exemption amount from estate tax is $5,340,000 and indexed to increase with inflation next year. Additionally, in the Tax Act of 2010 Congress introduced a new concept called “Portability” which allowed the surviving spouse to use any unused exclusion amount of the deceased spouse (i.e. DSUE … Deceased Spousal Unused Exclusion” amount). Therefore, if the deceased spouse left their estate to the surviving spouse, then the surviving spouse could still claim the deceased spouse’s estate tax exemption.
As a result, many planners are no longer emphasizing the “credit by-pass trust” (Bypass Trust”) as most clients seek simplicity and ease of understanding. However, there are reasons to continue recommending a Bypass Trust including the following:
- Divorce protection – if the surviving spouse remarries and subsequently divorces, the assets of the Bypass Trust are protected;
- Lawsuit protection – if the surviving spouse is sued, the assets of the Bypass Trust are protected
- Accidental disinheritance of the next generation – the surviving spouse cannot change up the estate plan of the deceased spouse
- It does not happen automatically. Failure of surviving spouse to make the portability election on a timely filed estate tax return (Form 706)
- Possible loss of DSUE amount by surviving spouse’s remarriage and death of new spouse
- No portability (i.e. you lose it) of the GST exemption (generation skipping tax) – the Bypass Trust preserves the GST exemption
- Uncertainty over calculating the DSUE amount of a deceased surviving spouse
Experienced and competent advisors can help a client understand the pros and cons of these strategies. Understanding leads to the implementation of a plan that works for the family.