Q. My wife and I had our Living Trust prepared back in the year 2001. I hear there have been changes in tax law since then which might affect us. Is it time to have our trust reviewed?
A. Yes, Indeed!. When you created your own trust, the estate tax exemption was much smaller than it is today, and special tax planning was required to minimize estate taxes for a married couple. At that time, your attorney probably recommended a form of trust tailored to the much lower estate tax exemption, which was then $675K per person. He or she likely designed a Trust with a Bypass Sub-Trust built into it. This Bypass Sub-Trust was sometimes called a “B Trust,” an Exemption Trust, a Family Trust, or a Credit Shelter Trust.
This design was to preserve the first spouse’s estate tax exemption for later use at the survivor’s later death. Under former law, without this design, if all trust assets transferred to the surviving spouse directly, the first spouse’s exemption would be unused and lost and all trust assets at the later survivor’s death could potentially be heavily taxed, as they would be then sheltered by only the survivor’s own $675K exemption. The excess estate value (if any) was then exposed to an estate tax at a rate as high as 55%. Understandably, couples wished to avoid that tax.
However, by directing a portion of the first spouse’s share into a ByPass Sub-Trust, rather than to the Surviving Spouse directly, the couple could shield from estate tax $675K + $675K, or a total of $1,350,000, over the span of two lifetimes.
Now, the estate tax exemption has increased dramatically, making the former use of ByPass sub-trusts unnecessary for most couples. By comparison, the former $675K estate tax exemption is now $13.61 Million per person per the Tax Cuts and Jobs Act (“TCJA”), effective for persons dying between 2018 and 2025. Unless Congress votes to extend that TCJA, which is set to expire in 2026, the estate tax for persons dying in years 2026 and thereafter will likely return to the prior exemption, which was approximately $5,250,000 (plus increases for inflation) under the American Taxpayer Relief Act (“ATRA”) signed by former President Obama. But even if the current law expires in 2026 and the exemption drops back to what it was under the ATRA, even that lower exemption (plus adjustment for inflation) would still be more than sufficient for most couples’ estates, and would eliminate the need for the mandatory ByPass Sub-Trust funding on the first death.
Question: You might ask why couples might now prefer to forgo a ByPass Sub-Trust. Answer: The typical Bypass Trust had some drawbacks: (1) the survivor typically lost the right to make any changes in the Bypass portion even if family circumstances had changed, (2) the survivor’s access to the assets in the Bypass portion was usually restricted, (3) the Bypass trust could interfere with applying for a Medi-Cal long-term care subsidy, (4) the assets in the Bypass portion usually did not qualify for a 2nd date-of-death “step-up” in tax basis upon the later death of the surviving spouse, with increased exposure to a later capital gains tax for appreciating assets when, and if, the ultimate recipients (usually the children) later opted to sell the appreciating asset(s), and (5) the Bypass Trust usually required separate accounting and annual income tax returns during the life time of the survivor. Surviving spouses usually found these restrictions burdensome.
Further, under current tax law, the unused portion of the first spouse’s full exemption can now be preserved for use by the second spouse even without the use of the restrictive Bypass Trust. The survivor need only make a proper election to preserve it by filing a timely Estate Tax Return Form 706 after the death of the first spouse.
In view of these new developments, couples with Bypass Trusts created for estate tax purposes under old tax law should have their trusts reviewed and, where appropriate, consider eliminating the mandatory funding feature at the first spouse’s death. Instead, they might now consider plans which give the survivor the option of doing post mortem planning after the first death, e.g. by funding a portion of trust assets into an optional Disclaimer Trust. The Disclaimer Trust would then operate as a tax-saving Bypass Trust if that option then appeared appropriate, whether to ensure full use of the 1st spouse’s exemption (without the need to file a timely Form 706 to so elect) and/or for non-tax reasons (e.g. creditor protection, assuring bequests to the deceased spouse’s designated beneficiaries).
An exception to the above recommendation: The use of the mandatory Bypass Trust can still be useful for non-tax purposes, e.g. in situations involving second marriages. Here, each spouse usually wishes to provide financial security for the survivor, but also wishes to preserve a portion of assets for his/her own children. Under these circumstances, a Bypass Trust can still help these couples achieve their estate planning goals.