BYPASS TRUST: What Is It and How Does It Work?

Bypass trust
Image source: Texas Trust Law

One of the crucial factors in estate planning is the bypass trust. It can help you avoid paying taxes on some of your assets when your spouse dies. But first, you need to understand how a bypass trust works and how it will be beneficial to you. And that’s what this article is all about. 

What Is a Bypass Trust?

A bypass trust is a legal arrangement that permits married partners to avoid paying estate taxes on certain assets when one spouse dies. When an AB Trust is established, it becomes both a marital trust and a bypass trust. The surviving spouse’s trust is referred to as the marital trust. The deceased spouse’s trust is known as a Bypass Trust. It is also known as a Family Trust or Credit Shelter Trust.

A marital trust is a revocable trust established for the benefit of the surviving spouse. The terms of a revocable trust can be altered by the person who founded the trust. The family or B trust is irrevocable, which means that its provisions cannot be altered.

When the first spouse dies, their portion of the estate is transferred to the family or B trust. The surviving spouse does not own those assets. However, he or she can access the trust and collect income from it during his or her lifetime. The estate component that does not go into the B trust is placed in the A or marital trust. This portion of the trust is entirely under the jurisdiction of the surviving spouse. They have the freedom to sell, spend, or give away assets as they see fit.

A bypass trust may be administered by the surviving spouse or by someone else. The trustee is responsible for ensuring that assets from the couple’s estate are split appropriately among the trust’s components. The trustee is also in charge of asset management, as specified in the trust’s provisions.

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 owing after the death of the second spouse. Without a suitable estate plan, the surviving spouse’s inheritance will most certainly include all their 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. And 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

The “A trust” is also known as a marital trust or survivor’s trust. This is because it retains assets for the use of the surviving spouse. 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. This 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 irreversible and 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 in order 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 a trustee, the surviving spouse does not own the trust assets. Thus, he or she 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 to utilize for specific expenses. These include health, education, maintenance, and support. (The money from this distribution would be deemed income and would have to be reported on their personal tax return.)

Who Stands To Gain 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. This 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 — and a bypass trust can still provide other benefits of an irrevocable trust, such as asset protection. If you or your spouse had 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.)

If you aren’t extremely rich or don’t have any children from a previous marriage, setting up a bypass trust, which may be time-consuming to form and administer, may not make much financial sense.

A basic irrevocable trust, like a bypass trust, can provide tax benefits and creditor protection while also reducing your taxable estate. As previously stated, irrevocable trust assets are not declared on your tax return. Thus, instead of being taxed at your income tax rates, they will be taxed at the estate and trust tax brackets. The trustee will pay the taxes from the trust assets. For further information, speak with a financial professional such as a tax accountant.

Why Should You Use a Bypass Trust in Estate Planning?

For married couples with significant 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.

Potential Drawbacks of 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. Hence, the surviving spouse is in charge of managing trust assets and keeping track of how the trust is spent. If the spouse is older, they can appoint someone else as trustee to perform such responsibilities. 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 alter. If lower estate tax exemption limitations are ever implemented, tax benefits for larger estates may be limited or eliminated.

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

A Living Trust is a revocable trust established while a person is still alive. On the other hand, a Bypass Trust is an irreversible trust established after death. A Bypass Trust can be established by a Living Trust or a Will. (A Living Trust can establish a Bypass Trust, but a Bypass Trust can never establish a Living Trust.)

A Living Trust is essentially an ownership structure in which property is kept in the name of a “trustee” rather than the name of the true owner. People nearly always set up Living Trusts for their own benefit, in order to avoid probate, address the risk of future incapacity, and keep affairs private.

The individual who sets a Living Trust usually identifies himself or herself as trustee and beneficiary. Upon that person’s death, all or a portion of the property remaining in the Living Trust is distributed in accordance with the conditions of the trust agreement.

Bypass Trusts are commonly established when a husband or wife dies in order to save taxes when the other spouse dies. When a married individual passes away and leaves everything to his or her spouse, the surviving spouse may be too wealthy to give everything to their beneficiaries tax-free. Being “too wealthy” usually means that the married pair is worth more than $5,430,000. (as of 2015). When the surviving spouse dies, the Bypass Trust protects the first spouse’s $5,430,000 exemption from taxation, doubling the amount that can be transferred tax-free to $10,860,000.

However, bypass trusts have non-tax benefits, and for some people, reducing taxes is not the primary reason for establishing one. Bypass Trusts, for example, shield the trust property from creditors’ claims and allow the deceased spouse to determine where the trust property goes after the other spouse dies.

What Is a Spousal Bypass Trust?

This is sometimes referred to as a “spousal by-pass trust,” though it should have been referred to just as a “by-pass trust” because the recipient was not necessarily a spouse. A spousal bypass trust is a trust established by the member/pension holder to collect pension death benefits.

Most providers give a spousal bypass trust (SBT) template, or a solicitor can draft one. Simultaneously, an expression of wish form is completed, requesting that any death benefits paid by the plan/trustees be paid to that trust. The member/pension holder appoints and directs the SBT trustees on how to disburse whatever funds the trust may eventually receive upon death.

When a member/pension holder dies, the plan administrator must use their judgment, but if an expression of wish form gives advice, they will normally pay to the SBT (unless the trustees believe that the situation warrants a differing course of action). It’s crucial to remember that where a scheme has discretion over the death benefits, the expression of wish is just that, and while the scheme will review the members’ wishes, they ultimately decide where the benefits go. The SBT trustees will often disperse the monies in accordance with the member’s instructions.

What If A Bypass Trust Is Never Funded?

If a Bypass trust is not funded or is funded late, the Internal Revenue Service may assess fines, fees, and interest. This is especially regrettable because the trust is no longer required to reduce estate taxes. A dissatisfied beneficiary may sue the surviving spouse to demand the formation and payment of the Trust, which is required.

In Conclusion

The significance of a bypass trust in your estate plan is mostly determined by the value of your estate. It also depends on how much estate tax you want your heirs or spouse to pay once you die. If the estate tax exemptions are reduced, you may require a bypass trust. A bypass trust, on the other hand, may be less effective if you don’t have as many assets to leave to your spouse. Finally, a bypass trust is an excellent approach to safeguard the riches you’ve worked so hard to accumulate.

Frequently Asked Questions

Is Qtip the same as bypass trust?

Qtip provides the same benefits as a bypass trust. However, the two are not the same.

Does a bypass trust get a step-up in basis?

Because an asset in a bypass trust passes outside of the spouse’s estate, it does not receive a step-up in basis.

What is another name for a bypass trust?

A bypass trust can also be called a residual trust, tax avoidance trust, or family trust.

Related Articles

  1. WHAT IS AN ESTATE? A Complete Guide
  2. Credit Shelter Trust: Pros and Cons
  3. TRUST ATTORNEY: Do I Need One?
  4. Wills and Trust Lawyer: Why Do You Need One?
  5. Disclaimer Trust: What are the Pros and Cons?


Leave a Reply

Your email address will not be published. Required fields are marked *

You May Also Like