The Montana Estate Lawyer

Monday, February 25, 2013

Do you still need a bypass trust?

Under the 2012 Tax Act families with estates of roughly $10 million or less do not face the specter of estate tax when mom and dad pass away.  That’s great (and overly broad), but it creates an issue for those families.

Most existing wills and living trusts contain a “bypass” trust or “credit shelter” trust to minimize estate tax and protect assets.  The first spouse to die transfers most or all of his estate to the surviving spouse in a trust that bypasses the second spouse’s estate for estate tax purposes even though the trust assets are available to the second spouse.  When the second spouse dies the assets are not taxed in his or her estate either.

That is good estate planning when a family faces estate tax liability.  How about when estate tax is not an issue?  Should that family get rid of their bypass trust?

Strictly from a tax standpoint, the answer might be “yes.”  That’s because, although a bypass trust can save estate tax, it can increase income tax.

Here’s how it works:   When the kids inherit an asset from their parents, there is no income tax at that point.  However, if they later sell an inherited asset that has appreciated, there will be capital gains tax.  It will be based on the difference between the sales price and what the kids are deemed to have paid for the asset, their “income tax basis.” 

With a bypass trust the kids’ income tax basis equals the asset’s value when the first parent died.  If there is no bypass trust, their basis will likely be the value when the surviving parent died. 

There’s the problem: capital gains tax on the appreciation between the dates of the parents’ deaths.  If one parent lives a long time after the other dies, there may be a lot of appreciation.  An asset held in a bypass trust will trigger tax on that appreciation (as well as the appreciation after the kids inherit). 

So, does that mean mom and dad should get rid of their bypass trust?  Being lawyers, we have the classic answer:  “It depends.”

If minimizing tax is all the family is concerned with then, yes, getting rid of the bypass trust may make sense.  However, we don’t think minimizing tax is the only issue to consider.

Trusts serve purposes other than minimizing taxes.  They allow families to protect assets from mismanagement - and creditors and predators.  A bypass trust can require a surviving spouse to obtain a premarital agreement if he or she wants to remarry.  That way the kids at least have a good chance of ending up with an inheritance.

What are some of the options in leaving property to the surviving spouse?  

  • Leaving property outright. 
  • Leaving property in another kind of trust. 
  • Keeping the bypass trust but revising it to deal with the tax issue.

Or a family can simply retain the bypass trust “as is.”  A family might take this approach if they’re not that concerned about a possible increased capital gains tax down the road but they are concerned about protecting assets – and minimizing legal expenses now.

The family must weigh the pros and cons.  But we think it’s an issue families should consider.


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