Given the generous exemptions against the Federal estate tax, many of our clients are moving away from traditional “bypass” trust planning. We are seeing this arise not only as married couples update their planning, but we also see the issue arise after one of them has died with a bypass trust in their Will. This article discusses each of these situations and options they present. Aside from this, one might want to learn things like can I open a savings account for my nephew.
Let’s consider the case of Adam and Eve, and assume Eve survives Adam.
Traditionally, a bypass trust was seen as the best of both worlds, a veritable utopia. Upon Adam’s death, Eve managed and had access to the trust assets, but these assets were outside her taxable estate at her later death. A “cap” was placed on the bypass trust at funding, being Adam’s estate tax exempt amount as of his death. Yet, the trust assets could grow beyond that cap and pass to their progeny (Cain and Abel) upon Eve’s later death, with no estate tax. The accepted trade-off for estate tax exclusion was greater exposure to capital gains tax following the survivor’s death. If the trust were not deemed a part of the survivor’s estate, the tax relief provision granting a step up in basis at death would not be available for the trust assets upon the survivor’s death.
Fast forward to 2013 when “portability” was added as a permanent tax law feature. In very general terms, portability can be thought of as a “carry forward” of the exemption of the first to die, which is then added to the exemption of the second to die at the second death. If Adam died in 2018 with an $11M+ exemption and Eve died in 2026 with a $6M+ exemption, a full $17M+ might be able to be sheltered from estate tax in 2026, without use of a trust. As a result, the bypass trust might not be as compelling to Adam and Eve, depending on the size of their estates.
At this point in the drama, Adam and Eve are tempted…to remove any trust for their spouse in their Wills. They are lured by the idea of going back to basics: a simple outright bequest of all their estate to their spouse, mostly so that all assets can enjoy a step up in basis at the second death. They figure that if estate tax is not looming large over them, they will focus on saving their heirs exposure to capital gains tax.
However, like many couples, Adam and Eve desire an estate plan to protect Cain and Abel from the wiles of the surviving parent (who we will posit has a history of bad judgment and) who might remarry or otherwise disinherit them. In short, trust planning is still compelling for this couple, but the bypass trust turns out not to be utopia for capital gains tax reasons.
This couple may be well advised to incorporate a trust for their spouse that can achieve all their wishes. They want a trust to control the assets to better assure their own children ultimately inherit their estate. They also want to elect that the trust be treated as if in the survivor’s estate, in order to get the basis adjustment when the second spouse dies. This election is made on the Federal estate tax return of the first to die, and is referred to as a “qualified terminable interest property trust election,” or “QTIP” election. In the past, many of our clients have had both a bypass trust and a QTIP trust in their [old] estate plan, and some of them may benefit from revisiting whether this should be distilled down to one trust at the first death.
Bear in mind that this is a very fact-driven decision, depending not only on the ages of the of the couple and their net worth, but also the nature of their assets (e.g., IRAs and retirement plans are outliers for some of the above purposes). Of course, one of the biggest variables is the vicissitudes of Congress, which is all but impossible to predict. Recent tax changes have shown us that an estate plan made in 2008 for the same couple may look quite different than that recommended in 2018. Feel free to contact one of the Farner & Perrin attorneys to assess your particular situation.
The second context where we are seeing an increased emphasis on basis planning is after the first spouse’s death, when the bypass trust is dictated in the first spouse’s Will. Eve comes in to probate Adam’s Will and indicates she would prefer not to fund his bypass trust, so Cain and Abel can enjoy a further step up in basis on the trust assets when she later dies. In Eve’s case, let’s assume she is under a nefarious (and slimy, shall we say) influence, and may well cut the boys out of her Will eventually. The law protects Adam’s wishes by requiring her to fund the trust as intended (even if in actuality he intended it only due to tax reasons).
However, in harmonious family situations, we have counseled clients who wish to enter into a family settlement agreement to forego funding the bypass trust, or to dissolve one that has been funded previously. But this must be analyzed against possible gift tax consequences and even the risk of a future lawsuit. For example, Eve must consider a grandchild who, as a minor, is not able to sign the settlement agreement and may otherwise stand to share in Adam’s estate as per the bypass trust in his Will.
In sum, Adam/Eve should not be too impulsive in biting at the chance to move away from trust planning, without proper legal advice. We at Farner & Perrin encourage each client to embrace making their own decisions and understand the ramifications of their choices.