Is It Time to Get Rid of that By-pass Trust?

A long standing strategy to avoid estate taxes may no longer be needed.

The by-pass trust has been a standard estate planning tool for quite some time. A somewhat typical plan for a married couple with a next generation is to set up a revocable living trust for each spouse. Upon the death of one of the spouses the living trust is used to fund a by-pass trust up with assets equal to up to the current estate/gift tax exemption amount, and roll everything else into a marital trust. The surviving spouse is allowed to utilize income and in certain cases, the principal in the by-pass trust to maintain their lifestyle and then get passed along to the next generation. The funds in the marital trust are typically available for any use by the surviving spouse.

This kind of set up used to be desirable when the estate/gift exemption levels were lower and before the 2012 tax relief laws were passed, which now allow the surviving spouse to utilize any exemption amounts left over from the first spouse to die (sometimes called portability).

As an example of what could happen if a by-pass trust were not used prior to the above, consider my parent’s estate.

Mom and Dad used a standard stationary living trust form to set up their trust. They were trustees. After their death, my brother was the designated successor trustee.

Dad died in 1983. Mom lived until 1996. The trust assets grew during that time to around $750,000. In 1983, Dad’s exclusion amounts could have been $275,000. However, they just disappeared when he died because there was no by-pass trust nor any exclusion ‘portability’. When Mom died in 1996, the exclusion amounts were $600,000. Because her estate was then valued at $750,000 it had to pay taxes on the amount above $600,000 ($150,000) at a tax rate of 55% ($82,500). If they had used a by-pass trust, the estate would not have owed any estate taxes.

Why get rid of the by-pass trust?

Federal estate taxes don’t kick in unless you die with more than 5 million dollars.

The most obvious reason to get rid of a by-pass trust if you aren’t a multi millionaire is because of the large exclusion amounts permanently put into effect by law and adjusted yearly to account for inflation.

Estate taxes were originally instituted to be a tax on the rich, to both fund the Federal coffers and to help keep concentrated wealth out of the hands of a few families. Over the years as inflation deflated the value of our assets, it started hitting the not so rich.

Most folks don’t have an estate worth more than the exclusion amount. There are about 1.2 million households worth $5 million to $25 million as of 2015 out of about 116,926,305. So, only about 1% of American households meet the criteria of even having an estate equal to the exclusion amount.

So, unless and until laws change again, most of us won’t even owe any estate taxes.

It isn’t needed to utilize each spouses gift/estate tax exemptions.

Because the surviving spouse can now use the remaining exclusion amounts left from the deceased spouse, the by-pass trust (set up to do just that) is probably excess baggage.

Although American now has about 10.4 million millionaires – according to the research done by the Spectrum Group, only 1.2 million of those have more than $5 million dollars. But even if you both have $5 million dollars, your combined estate is currently still less than the combined exclusion amounts for both spouses ($5.49 million each).

Use of the deceased spouse’s exclusion amount is NOT automatic. An election to use it must be made on an estate income tax filing.

By-pass trusts must pay income taxes at a much higher rate than individuals pay.

Tax laws in the US specify different rates for different income levels, but what you might not know is that different kinds of taxable entities have different cutoffs for those rates.

For example, you as an individual person (married filing jointly) can have taxable income up to $75,300 in income to be taxed at the 15% rate. A trust, such as the by-pass trust, on the other hand, can only earn up to $2550 before hitting the next higher tax rate AND if the trust earns more that $12,400 (as any hefty estate trust is liable to do) it pays the highest tax rate of 39.6%. Add to that, the virtual certainty that you WILL need to use a qualified accountant to prepare your taxes and your spouse may be cursing you after you die.

Income from a by-pass trust may be subject to double income tax payments.

If the trustee of the trust decides to distribute the income from the trusts to the beneficiaries, so that it can be taxed at the lower rates, the person preparing the trust income tax return must properly claim a ‘Distributable Net Income’ to avoid having the trust also pay taxes on the income passed to the beneficiary.

By-pass trusts may pay higher capital gains taxes.

Capital gains taxes on most individuals are taxed at the 15% rate – some pay no capital gains taxes while the high earners pay 20%.

Trusts on the other hand (once they hit income of $12,300) pay 20% and also have to pay the net investment income surcharge (another 3.8%) as well.

To add insult to injury, unless a trust is worded to avoid this, capital gains may not be included as income and therefore can’t be distributed to avoid high trust taxes.

By-pass trusts can cause complexity in administration and in tax preparation.

If your estate plan was set up before current legislation went into effect, it may be worded to roll all of the deceased spouse’s assets into the by-pass trust – up to the exclusion amount and then everything else into a marital trust.

Ours is like this. If one of us were to die to day, due to the huge exclusion amounts, that persons assets would all go into the by-pass trust. There are more restrictions on what the trustee can use the money in a by-pass trust for. Trying to figure out what can and can’t be done can be difficult for the survivor at an already difficult time.

Trying to keep each spouse’s initial living revocable trust balanced with equal assets can also get cumbersome.

Maintaining separate accounts for each of the spouse’s living trust can also add complexity and expense in some cases.

As noted above, if the by-pass trust is funded at the death of the first spouse, it will most likely be imperative to have a professional prepare the taxes for it, yet another added expense.

Assets held within a by-pass trust may not get the cost basis adjusted to market value when the grantor dies.

This could cause heirs to pay huge capital gains taxes when the asset is finally distributed to them.

As an example, I own some shares of my company stock (quite a few shares) which have a cost bases of around $7 a share. These shares sell now for upwards of $115 a share. If the cost bases were to be adjusted at my death, the kids wouldn’t have to pay capital gain taxes if they sold right away. If not, they would end up paying $21.60 a share in capital gains (115 – 7 * 20%).

Do you still have a by-pass trust?  Why are you keeping it?