Bypass trusts can reduce estate taxes significantly in limited cases, for example if assets are expected to appreciate dramatically. They may be useful if there is a nontax reason for creating a trust, such as asset protection or to control spendthrift activity. But bypass trusts are generally not needed for estate planning purposes as a result of the American Taxpayer Relief Act of 2012’s making permanent the new portability provisions along with the $5 million estate tax exemption. The following example which uses simplified assumptions and tax rates shows how this can occur.
EXAMPLE 5-1 A physician estimates her taxable estate at $5 million, and her husband has an additional $5 million of his own property. Because the husband is a conservative spender, it is entirely possible that he can live off the income on his own assets and that any assets bequeathed to him will not be depleted. Under those circumstances, if the husband receives $5 million from his wife at her death, he may have a taxable estate of $10 million when he dies. Under prior law, a bypass trust would be used to save estate taxes by taking advantage of the exemption for the first spouse to die. But under the new law, a bypass trust is unnecessary because the second to die spouse can use the other spouse’s $5 million exemption along with his or her own.
However, if very large growth in asset value is expected, a bypass trust may save taxes.
EXAMPLE 5-2 Same facts as in the previous example except that the estate property is expected to appreciate to $20 million by the second spouse’s death. If the spouses use a bypass trust and fund it with $7 million at the first death when the exemption is $5 million, the estate will be subject to estate tax on $2 million on the $7 million bypass trust share but the appreciation on the $7 million in the bypass trust will escape estate tax. If the exemption is $6 million at the second death, the surviving spouse will pay no estate tax if a bypass trust is used. But if a bypass trust is not used, the surviving spouse will face estate tax on $9 million ($20 million property value less $5 million exemption for first death and $6 million exemption for second death). Even in this favorable case, though, a bypass trust may not result in a tax savings. The effect of a basis step-up at death and the relative income tax rates of individuals and trusts must also be considered. The effect of state estate tax laws must also be taken into account. If the state estate tax exemption amount is relatively low (say $1 million) then a bypass trust may result in tax savings.
Reference: Estate and Retirement Planning Answer Book by William D. Mitchell ©2013 Wolters Kluwer. All rights reserved.