BYPASS TRUST: Definition and How It Works

Bypass Trust
Elder Law Answers

Creating an estate plan is a crucial step in asset management. This is especially important if you are married and intend to leave assets to your spouse. Depending on your financial objectives, a bypass trust may be beneficial to your estate planning.

What is a Bypass Trust?

A tax bypass trust, also known as an exemption or A/B trust, is designed to reduce or eliminate a married couple’s estate tax liability. It is typically set up as an irrevocable trust. This means it cannot be altered or invalidated without the approval of the trust receiver. It owns the property of the first spouse to pass away. However, the surviving spouse retains access to the trust funds. They can, for example, utilize the trust income and principal to pay medical expenditures.

A person may transfer their estate to their spouse without paying taxes on specified property in the event of death. However, if the second spouse dies and leaves the estate to the children, any assets over the $11.58 million exemption limit are taxed at rates of up to 40%. That means a single parent should not leave their children assets worth more than $11.58 million if they do not want the assets taxed. Married couples have a limit of $23.56 million.

How Does a Bypass Trust Work?

Assume a couple’s estate is worth more than the federal estate tax exemption. The marital deduction, which allows for a tax-free transfer of assets between spouses, allows the estate of a deceased spouse to pass to the surviving spouse without any estate tax being paid.

However, estate taxes may become due after the death of the second spouse. Without a suitable estate plan, the surviving spouse’s inheritance will most certainly include all the deceased spouse had, perhaps exceeding the estate tax exemption. This will eventually reduce the amount of money left for future recipients, most likely their children.

You can avoid estate tax by transferring your assets to a bypass trust. So, when your spouse dies, the trust assets are allocated to the final beneficiaries.

You can divide your assets between two trusts using a bypass trust to keep their values below the federal estate tax exemption. Because it is made up of two different trusts — the A and the B — a bypass trust is also known as an AB trust.

The A Trust

Because it retains assets for the use of the surviving spouse, the “A trust” is also known as a marital trust or survivor’s trust. The trust is often revocable, with the surviving spouse acting as trustee and having the authority to amend it as well as utilize and spend the assets as they see fit.

The B Trust

The “B Trust” is an irrevocable trust that holds all other assets up to the estate tax exemption, which is why it’s also known as a credit shelter trust or decedent’s trust.

If a married couple was planning today, the B trust should have assets worth less than $12.06 million. The bypass trust’s final beneficiaries are normally the couple’s future heirs, such as their children. However, a surviving spouse may be allowed to receive unearned trust income.

When the second spouse dies, the assets in a bypass trust are not subject to probate and transfer directly to the final beneficiaries. They are exempt from estate taxes since the B trust is irrevocable. They cannot be altered or terminated except under specific conditions set down by state law. The trust owns the assets which do not belong to any individual.

You should consult with an estate planning professional to write the terms of the trust instrument since it must contain specific language to function legally as a bypass trust under IRS tax rules.

Can a Surviving Spouse be the Trustee of a Bypass Trust?

The surviving spouse may, and frequently does, function as trustee of the bypass trust’s B trust. Remember that as trustee, the surviving spouse does not own the trust assets and cannot utilize them for personal gain. The bypass trust property is not reported on the surviving spouse’s tax return. They will file bypass trust taxes separately as the trustee.

In compliance with the IRS tax code, the surviving spouse may be allowed to receive the bypass trust income from utilizing it for specific expenses—health, education, maintenance, and support. The money from this distribution would be deemed income and must be reported on their tax return.

Who Benefits From a Bypass Trust?

If you’re not concerned about paying estate taxes, you don’t need a bypass trust. It’s more difficult to exceed the estate tax exemption, which has been set high under current tax law.

Furthermore, another tax reform passed in 2012 provided for portability, which meant that married couples could pool their federal exemption together (up to a total of $24.12 million in 2022), minus any portion of the exemption used during the deceased spouse’s lifetime.

However, the statute is open to change—the exemption amount will expire after 2025 unless Congress takes additional action. A bypass trust can still provide other benefits of an irrevocable trust, such as asset protection. If you or your spouse have children from a prior marriage, a bypass trust can help ensure that the inheritance is distributed to the beneficiaries of your choice. (For example, you may wish for the assets to be distributed to your kid rather than the surviving spouse’s stepchild or a new partner.)

The Advantages of a Bypass Trust

Couples typically establish a bypass trust for the following reasons:

  • To avoid wasting estate tax exemptions. This is a legitimate approach to decreasing or eliminating your descendant’s inheritance tax obligation; why not take advantage of it?
  • In order to avoid probate
  • To settle debts and distribute assets to heirs.
  • To ensure that if the surviving spouse marries or follows a different estate plan for possessions in the A trust, those in the B trust are distributed in accordance with the deceased’s wishes.

Why Should You Use a Bypass Trust in Estate Planning?

For married couples with large assets, a bypass trust can reduce federal (and state) estate tax.

Assets up to an annual exemption amount are not subject to federal estate tax with the family or B portion of the trust. The cap for 2019 is $11.4 million, which doubles to $22.8 million for married couples. If the assets in the family trust do not exceed that amount, they are not liable to federal estate tax.

The surviving spouse’s assets under a marital trust are not subject to federal or state estate tax. The surviving spouse can also provide his or her heirs with tax and credit shelter benefits. Secondary trusts can hold assets for the benefit of children or grandchildren.

Furthermore, assets held in a bypass trust allow the surviving spouse to avoid probate. That is the legal procedure regulated by the court system for inventorying a deceased person’s assets. It also settles debts and distributes assets to heirs. Probate does not apply to assets kept in a bypass or other sort of trust.

Assets for Funding a Bypass Trust

A bypass trust can be funded by nearly any asset owned by the estate. Working together, the surviving spouse and his or her attorney choose which assets should be placed into the trust at the time of the first death to achieve the optimum tax consequences. Some of the finest assets to fund a bypass trust are cash, life insurance, a discounted part in a firm, and rapidly appreciating shares. Other assets, such as IRAs, installment contracts, E-bonds, and annuities, are less effective because the beneficiary must pay income taxes on the money received from those assets because the decedent did not pay income taxes on those assets.

Potential Drawbacks of the Bypass Trust

Creating a bypass trust can be expensive and time-consuming. An estate planning attorney who specializes in this sort of trust is usually required. If you don’t have a lot of assets, the estate tax benefits may not be worth the cost of setting up the trust.

Such trusts must also be maintained on an ongoing basis. As a result, the surviving spouse is in charge of managing trust assets and keeping track of how they are spent. If the spouse is older, they can appoint someone else to act as trustee. Because the trustee is entitled to a charge for their services, this increases the cost of the trust.

A bypass or B trust does not provide the surviving spouse complete control over the trust’s irrevocable assets. There may be limitations on how much money a surviving spouse can get from the trust. Planners must ensure that enough assets are left out of the B trust to provide financial support for the surviving spouses.

A bypass trust does not also ensure exemption from state estate tax. Depending on your state’s regulations, you or your spouse may still owe estate tax at the state level on assets received when either of you dies. Meanwhile, federal estate tax legislation could be altered. If lower estate tax exemption limitations are ever implemented, the tax benefits for larger estates may be limited or eliminated.

What is the Difference Between a Marital Trust and a Bypass Trust?

The surviving spouse can usually access both the income and the principal balance of the marital trust. The principle in a bypass trust can be used for surviving spouse expenses such as health and support. However, it is not normally accessible to the surviving spouse.

Other Things to Consider

Higher-appreciating assets should be placed in the B trust, where they will be valued from the date of the first spouse’s death but will not be taxed until the second spouse dies. The logic here is that the asset will continue to appreciate.

Finally, the trustee must assess the fair market value of the trust assets as of the death date of the first spouse. This can be inconvenient given the fluctuating values of stocks, real estate, funds, and other assets.

Conclusion

If you and your spouse have a bypass trust, ask yourself if you truly need it. Get expert guidance from someone who is current on tax rules as well as your current financial circumstances. Given the uncertainties surrounding federal estate tax legislation, you may elect to maintain the trust in case the estate tax exemption is reduced again, and you face a national tax obligation. Alternatively, you might include a “disclaimer” clause in the trust that allows the surviving spouse to choose whether or not to use the trust’s intricate tax-saving provisions.

The value of your estate mainly determines the significance of a bypass trust in your estate plan. It also depends on how much estate tax you want your heirs or spouse to pay when you die.

If the estate tax exemptions are reduced, you may require a bypass trust. On the other hand, a bypass trust may be less effective if you don’t have as many.

Bypass Trust FAQs

Who are the beneficiaries of a bypass trust?

If a married couple was planning today, the B trust should have assets worth less than $12.06 million. The bypass trust’s final beneficiaries are the couple’s future heirs, such as their children. However, a surviving spouse may be allowed to receive unearned trust income.

What is the difference between a bypass trust and a survivor's trust?

When the surviving spouse passes away, the assets in the Bypass Trust are distributed to the ultimate beneficiaries (which are usually the children of the first spouse to die). In contrast, a Survivor’s Trust is frequently revocable. The Survivor’s Trust is the estate’s share for the surviving spouse.

Can surviving spouse change bypass trust?

Despite the fact that the Bypass Trust is ordinarily irrevocable, it can be amended during the life of the surviving spouse. To accomplish this, all beneficiaries must consent to the adjustments.

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