A bypass trust is a device used to minimize a married couple’s federal estate taxes. It’s an arrangement that lets both spouses fully utilize their applicable exclusion amounts.
When the first spouse dies, the bypass trust receives that person’s assets up to the amount exempt from federal estate tax under the tax law—$5.34 million in 2014. So for someone who dies in 2014, up to $5.34 million could be placed in the bypass trust to escape federal estate taxation. The bypass trust can also provide asset protection, preserve estate assets for beneficiaries such as children or grandchildren, and provide income for someone other than the surviving spouse.
The remainder of the deceased spouse’s assets may go directly to the surviving spouse or into a marital trust. In either case, this portion isn’t taxed at the first death because of the unlimited marital deduction available for surviving spouses who are U.S. citizens.
The bypass trust often pays income for life to the surviving spouse. The principal typically remains in the trust until the second spouse dies, when it passes to the heirs without being included in the surviving spouse’s gross estate. The surviving spouse may have rights to use the principal in several ways. Included may be the right to invade principal for health, education, support and maintenance needs; a limited power of appointment over the principal; and the right to annually withdraw the greater of $5,000 or 5% of the principal. The surviving spouse may serve as trustee of a bypass trust, subject to certain limitations in the trust document so that the tax benefits in the arrangement won’t be lost.
When the surviving spouse dies, all assets in the bypass trust go to the successor beneficiaries without being included in the surviving spouse’s gross estate; that’s the bypass feature. An alternative: assets could remain in the trust and be held for the benefit of the successor beneficiaries if desired. Although bypass trusts are typically used by married couples to benefit the surviving spouse, they can also be set up to provide income for someone other than the spouse. A trust might be payable to the couple’s children or grandchildren, for example, or for a dependent parent or other relative. However, when including a grandchild as a successor beneficiary keep the generation-skipping transfer tax in mind. Although the trust beneficiary is frequently a relative, that’s not a requirement.
A bypass trust lets both spouses fully utilize the federal estate applicable exclusion amount permitted under the Internal Revenue Code. The trust may be set up to benefit not just the spouse but anyone, such as children, grandchildren, and other relatives. Other minor adjustments to the trust terms can provide a “customized” trust arrangement to meet many different needs, paying careful attention to the tax consequences. The critical point to remember is that the primary goal in setting up a bypass trust is estate tax savings.