As the lifetime estate tax exemption has risen, estate planners have found themselves enjoying greater breathing space when optimizing the amount of wealth that can pass to an estate’s heirs tax-free. In 2014, estate tax protection covers $5,340,000 per person. While the steadily larger exemption has seemingly made so-called “bypass trusts” less relevant, such trusts actually still have a valuable potential place in estate planning.
A bypass trust (also known as a credit shelter trust or AB trust) allows a person to divide an estate into two trusts — one trust containing up to half of his or her federal estate tax exemption at the time of death, and the second containing the remaining portion. Alternatively, the surviving spouse could receive the entire estate, but such an option wastes the exemption for the deceased spouse; assets above the exemption are subject to federal tax.
With the use of a bypass trust, the surviving spouse can become an income beneficiary. All income generated by bypass trust assets go to the survivor. Meanwhile, the assets within the trust are sheltered from taxes because of the deceased spouse’s exemption. The surviving spouse has his or her own estate tax protection, effectively doubling the exemption available to be passed on to children or other heirs.
But with the passage of the Tax Relief Act in 2010 and the permanent extension of its provisions by the American Taxpayer Relief Act of 2012, the estate tax exemption became portable: that is, the executor of an estate can elect to pass along any remaining tax exemption to a surviving spouse.
Still, the bypass trust has retained its usefulness. Assets within a bypass trust are generally shielded from creditors of the surviving spouse, which also protects those assets from creditors should the surviving spouse remarry. Upon the death of the surviving spouse, any assets within the bypass trust that have appreciated are not subject to the estate tax.
Because the estate's tax exemption is determined at the time of death and is not adjusted for inflation, bypass trusts can especially benefit assets with a strong possibility of appreciation. For these and other reasons, it is important for married couples to consult an experienced estate-planning attorney to find out if a bypass trust is appropriate for them.