A “Bypass Trust” is commonly set up at the death of the first spouse to receive the share of the trust assets of the deceased spouse to pass away. Such trusts are also called such names as Exemption, Decedent’s, or Credit Shelter Trust. Many of these trusts were set up when the estate tax exemption was much lower than our present $11,140,000 and made a lot of sense then. The assets were held in trust usually for the benefit of the surviving spouse but then escaped estate tax at his or her passing because the surviving did not have any power of the trust that would make it includible in his or her estate for estate tax purposes.
The surviving spouse could even be the trustee if he or she could only take out what he or she need for “health, education, maintenance and support”. This is the so called “ascertainable standard” of Internal Revenue Code Section 2041(b)(1)(A). This restriction paired with the restriction also in Section 2041(b)(1) that the surviving spouse not have the power to appoint trust assets in favor of himself/herself, his or her estate, his creditors, or the creditors of his or her estate make the bypass trust escape not includible in the taxable estate of the surviving spouse for estate tax purposes.
That exclusion make a lot of sense when the estate tax exemption was only $600,000 or even $1,000,000. The assets of many couples exceeds such amounts today. However, it does not make sense when their assets total less than $5,600,000, the eventual estate tax exemption when the exemption goes back down under the present law in 2026 or if Congress and the President lower it before then.
The reason for the estate taxation exclusion not making sense for most surviving spouses is that the escape from estate tax also makes the assets not receive the typical step up in income tax basis at the passing of the surviving spouse. See IRC Section 1014(b). Many of these trusts have highly appreciated assets. The remainder beneficiaries will be taxed on such capital gain if the trust or they sell any of such assets after the passing of the surviving spouse.
The typical amendment is to give the surviving spouse the power to appoint bypass trust assets to the creditors of his or her estate. This power would then qualify as a “general power of appointment” under IRC section 2041(b)(1) and so would make the bypass trust assets included in the taxable estate of the surviving spouse.
Notwithstanding, a bypass trust can be amended in all states. It will likely require court approval, but the expense of such will likely pale in comparison to the income from capital gain to be saved by the remainder beneficiaries.
Another advantage of going to court is the court may allow the termination of such trust. Hence, the surviving spouse will no longer need to file an annual income tax return for such trust. The surviving spouse also would no longer need to worry about getting the bulk of the income out of such trust each year. Such trust gets into the highest 37 percent income tax bracket at only $12,000 of taxable income. The surviving spouse gets into the top bracket at $500,000 of taxable income. Most surviving spouses are in a lower bracket and so has to remember distribute the income out of the trust each year to shift taxation to herself/himself.
In conclusion, all surviving spouses with a bypass trust should take a look at their situation to see if terminating or at least modifying the trust. StakerLaw would be honored to assist if the surviving spouse resides in California.
By Kevin Staker
California Estate Planning Blog by Kevin Staker 