The easiest way for a married couple to reduce estate taxes is to include a bypass trust in their wills. A bypass trust is also referred to as a credit shelter trust, an exemption equivalent trust, disclaimer trust or an A-B trust. A trust is a legal entity separate from the trustee or beneficiary of the trust.
1. Maximum Use of Amounts Exempt from Estate Taxes.
Bypass trust provisions allow a married couple to fully utilize the amount exempt from estate taxes in both spouses’ estates instead of only the surviving spouse’s estate.
For example, David and Martha, American citizens who own assets worth $4,000,000, sign simple wills that leave everything to the surviving spouse. David dies in 2018. David’s estate pays no federal or state estate taxes. Martha dies in 2018 when her estate is worth $4,000,000. Her estate pays approximately $212,980 in estate taxes.
In comparison, David and Martha, American citizens who own assets worth $4,000,000, sign wills that include bypass trust provisions. David dies in 2018. A portion of David’s estate (up to $2,000,000 in 2018) passes to the bypass trust. David’s estate pays no federal or state estate taxes. Martha dies in 2018 when her estate is worth $2,000,000. Her estate pays no estate taxes. By using a bypass trust, David and Martha will save approximately $212,980 in estate taxes.
2. Distributions for Spouse.
A bypass trust can allow a surviving spouse to use the trust income and principal as necessary for the surviving spouse’s maintenance, education, support and health if the surviving spouse acts as the trustee. If the surviving spouse is not the trustee, then the surviving spouse can receive distributions for other purposes such as travel and comfort. A surviving spouse can also receive a power to withdraw 5% of the trust principal or $5,000 each year without having the trust included in the surviving spouse’s estate.
3. Ultimate Beneficiary of Trust.
The bypass trust that must be set up at the time of death can include a provision allowing the surviving spouse to change the ultimate beneficiaries of the bypass trust. The broadest class of individuals and organizations that can receive the bypass trust remainder would be any person or organization except the surviving spouse, the surviving spouse’s creditors, the surviving spouse’s estate, and the creditors of the surviving spouse’s estate. This allows the surviving spouse to give the trust remainder to beneficiaries never intended by the decedent spouse.
For example, David and Martha own assets worth $4,000,000. Martha dies in 2018. Martha’s will provides that a portion of her estate up to the amount exempt from Washington state estate taxes ($2,000,000) transfers to a bypass trust for David. The bypass trust provides that David can appoint the remainder of the trust in his will to anyone excluding his creditors, himself, the creditors of his estate and his estate. David marries Elizabeth. David appoints the trust remainder to Elizabeth.
However, if the surviving spouse does not receive some flexibility in changing the ultimate beneficiary, a remainder beneficiary could challenge the trustee’s investment policy or the trust expenditures for the surviving spouse. Of course, the ability of the surviving spouse to change the ultimate beneficiaries of the bypass trust can be limited to a small class such as only descendants and charities. A person can also limit his or her surviving spouse to trust income and principal for limited purposes and require that the trust remainder automatically pass to specified beneficiaries on the remarriage or death of the surviving spouse.
For example, David and Martha sign wills that include bypass trust provisions. The bypass trusts provide that the surviving spouse cannot change the ultimate beneficiaries of the trust. Martha dies. David uses the bypass trust to pay for household expenses and a new car. David is also the trustee and invests the trust to produce the maximum amount of income. David and Martha’s child, Martin, decides that David should not use the bypass trust for those expenditures and should invest the trust for growth. Martin could sue David as trustee for not investing the trust as a prudent trustee.
In comparison, if the bypass trust allows David to change the ultimate beneficiaries between descendants and charities, then David could tell Martin, “Thank you for sharing your concerns, but your share is now going to my favorite charity.”
Couples need to decide how much flexibility the surviving spouse can exercise in choosing the ultimate beneficiaries of a bypass trust.
If the only reason for the bypass trust is the ability to reduce estate taxes, then the surviving spouse should be able to change the ultimate beneficiaries among a large group of beneficiaries, since if the surviving spouse received everything outright, then the surviving spouse could give the property to anyone.
If a couple or one spouse is concerned that the surviving spouse will remarry and name the new spouse as the trust beneficiary, then the surviving spouse’s ability to change the ultimate beneficiary of the bypass trust should be limited. An appropriate class may be to allow the surviving spouse to change the ultimate beneficiaries between descendants and charities.
If the couple wants the surviving spouse to use trust income and principal during his or her lifetime but wants to make sure that the children receive the trust remainder, then the surviving spouse should not be allowed to change the ultimate beneficiaries of the bypass trust. In that case, the couple should consider naming a trustee that is not the surviving spouse or the children. An independent trustee would be able to act in the best interests of both the surviving spouse and the children since it will not have any conflicts of interest in administering the trust. An independent trustee can preserve the family relationship between a surviving spouse and children since the additional strain of financial decisions will not interfere. An independent trustee can be a third-party individual (a friend) or a corporate trustee.
Although a surviving spouse may want the security of knowing that he or she controls the trust assets as the trustee, the surviving spouse must respect the bypass trust as a separate entity. The trustee cannot commingle the trust assets with the surviving spouse’s assets. The trustee titles the trust assets in the name of the trust, uses the trust’s tax identification number which is separate from the surviving spouse’s social security number, tracks expenses, makes distributions and prepares income tax returns for the trust each year. Generally, the benefit of a professional trustee exceeds the cost of a professional trustee. Before a person names a professional trustee, they should discuss the trustee’s charges and approach to trust administration. The trustee must invest the trust as a prudent person would invest the money unless the trust provisions state otherwise.
5. Assets to Fund Trust.
The estate can use almost any asset to fund a bypass trust. The surviving spouse and his or her attorney, working together, decide at the time of the first death what assets should be placed into the trust to create the best tax consequences. Some assets such as cash, life insurance, a discounted interest in a business and quickly appreciating stock make some of the best assets to fund a bypass trust. Other assets such as IRAs, installment contracts, E-bonds and annuities do not work as well since the recipient must pay income taxes on the money received from those assets because the decedent never paid income taxes on those assets.
6. Creation of Trust.
A married couple must include the language to create the bypass trust in the wills or revocable living trust signed during the couple’s lifetime. The trust only comes into effect upon the death of one of the spouses. The language in the will then allows the personal representative or trustee to obtain a tax identification number for the trust and place the decedent’s assets in the trust.
A married couple with assets in excess of $2,193,000 in 2018 should consider using a bypass trust to reduce the estate taxes on the second death if they want to pass everything to the surviving spouse but use the amount exempt from estate taxes in both estates. A married couple can create a bypass trust in their wills or revocable living trust to include a lot of flexibility for a surviving spouse.