Remember the “Fiscal Cliff”? In late 2012, you couldn’t turn on your TV, fire up the Internet, or glance at your smart phone without seeing some talking head chattering about how America as we know it would end if President Obama and Congressional Republicans couldn’t come to a deal to avoid the dreaded Fiscal Cliff.
When it was all said and done, the “lifesaving” Fiscal Cliff Legislation was comprised of $500 Billion in automatic tax increases and across-the-board spending cuts, and was generally regarded as a really bad thing for the U.S. economy. Fortunately, bipartisanship (sort of) prevailed, and the American Taxpayer Relief Act of 2012 (“ATRA”) was passed in time to keep us from going over the Cliff.
One important aspect of ATRA was that it brought some stability to federal estate taxes. In the decade prior to the enactment of ATRA, the amount that could be exempted from the federal estate tax bounced around from $1 million to $5 million and the estate tax rate varied from 35% to 50%. The estate tax was even abolished for one year (2010). With the passage of ATRA, the amount of the individual estate tax exemption was set at $5.25 million, indexed for inflation (it is $5.43 million for 2015), and the estate tax rate was set at 40%. Another important change was that a deceased spouse’s unused estate tax exemption became “portable” to a surviving spouse upon the filing of a timely estate tax return.
How did the old law operate? Prior to ATRA and the advent of “portability,” if a deceased spouse left all his assets to his spouse, the couple’s full wealth would be included in the surviving spouse’s estate, but the surviving spouse would only have her own estate tax exclusion to shield their combined wealth from estate tax. The only way then for a married couple to both provide for a surviving spouse and use both spouses’ estate tax exclusions was by funding a Bypass Trust (also known as an “AB Trust”) at the first spouse’s death. The Bypass Trust would be funded with as much of the deceased spouse’s property as could be passed free of estate tax using his exclusion, and would then pass tax-free to the couple’s heirs after the surviving spouse’s death. The Bypass Trust would thus provide for the surviving spouse, but still allow both spouses to use their individual exemptions to maximize what passed to heirs free of estate tax.
The combination of the relatively low estate tax exemption levels and the lack of portability resulted in the creation of thousands upon thousands of Bypass Trusts in the years up through 2012. However, since the enactment of ATRA, Bypass Trusts have been cast aside by many commentators and practitioners as a relic of the past (kind of like pet rocks and pay phones).
After all, who needs a Bypass Trust when a married couple can pass up to $10.86 million (in 2015) free of estate taxes via portability?
The answer to that question may very well be you!
Careful planners realize that are still several potential benefits to a Bypass Trust, and several reasons why you might want to keep the one you have, or establish one as part of your new estate plan. Here are some of those reasons:
- Nothing In Washington Is Really Permanent. While the estate tax changes in ATRA are supposed to be “permanent,” no law is truly permanent if the political will exists to change it. In fact, President Obama’s Proposed Budget for 2016 called for reducing the estate tax exemption to $3.5 million and increasing the estate tax rate to 45%. Previous Obama budget proposals have targeted portability directly. In his 2015 budget, President Obama proposed restricting portability by only allowing a surviving spouse to use the remaining gift tax exclusion that the deceased spouse could have used for lifetime gifts during the year of the deceased spouse’s death.
None of these changes have been enacted, but someday they might be and portability could theoretically be eliminated in its entirety. In such a situation, only married couples with a Bypass Trust would be able to double the amount of their estate tax exemption.
- Protecting the Intentions of the First Spouse to Die. When assets are left directly to a surviving spouse, that spouse often has the right to change the trust terms. The Bypass Trust is irrevocable on the first spouse’s death, so it locks in the intentions of the first spouse to die. This can be particularly important in situations where one or both spouses have children from a previous relationship or where there’s a concern that the surviving spouse might change beneficiaries in a way that would be unacceptable to the deceased spouse.
- Protection from Creditors. The irrevocable nature of the Bypass Trust should provide the assets placed in that trust with some measure of protection from the creditors of the surviving spouse. This is because while the surviving spouse would be a potential beneficiary of the Bypass Trust, he or she does not actually have ownership of the assets in that trust.
- Saving Taxes on an Appreciating Asset. If a married couple owns assets that are likely to greatly appreciate in value (perhaps valuable real estate or an ownership interest in a successful business) the Bypass Trust can help save or perhaps even completely avoid estate taxes. By placing such assets in the Bypass Trust at the death of the first spouse, those assets may now appreciate in value between the first death and the second death, and completely escape federal estate taxes when those assets pass to the children after the death of the second spouse.
- Protection against Generation-Skipping Transfer Taxes (GSTT). The GSTT taxes assets that skip a generation, such as a gift by a grandparent to a grandchild. If the combined amount you might leave to grandchildren or others who would be subject to GSTT is likely to be more than $5 million, you might want to consider a Bypass Trust to ensure that the first spouse to die’s GSTT exemption can shield assets passing to grandchildren from this tax as the GSTT exemption is not portable to a surviving spouse.
- Protection against State Estate and/or Inheritance Taxes. Approximately 20 states impose an estate and/or inheritance tax in addition to the federal tax (I’m looking at you New York, Massachusetts, Pennsylvania, Illinois and others). If you live in one of these states, you might want to use the Bypass Trust to be sure that each spouse is able to exempt as much of their estate as possible from state estate tax, as state estate tax exemptions are generally not portable under current state laws.
At the end of the day, there is no “one-size-fits-all” approach. Please contact our office if you are concerned about the Bypass Trust you have in your current estate plan, or if you want to discuss the pros and cons of establishing one in your particular situation.
Jarom Bergeson is an associate attorney with Kyler Kohler Ostermiller, and Sorensen, LLP (“KKOS Lawyers”) in its Cedar City, Utah office and has extensive experience in helping client register their trademark and protecting their brand identity. He can be reached at [email protected] or by phone at (888) 801-0010.