The American Taxpayer Relief Act of 2012 (ATRA) was signed into law on January 2,2013. It made permanent a $5 million dollar "estate tax exemption amount", indexed for inflation. (For 2013, the estate tax exemption amount is $5.25 million dollars).
ATRA also made permanent the concept of "portability". Portability means that a surviving spouse benefits from the deceased spouse's unused estate tax exemption without the need for a "bypass trust".
Bypass trust planning allowed the surviving spouse to avoid wasting the deceased spouse's estate tax exemption. Without bypass planning, the deceased spouse's estate would transfer to the surviving spouse with no estate tax liability. But, the deceased spouse's exemption was wasted, and upon the surviving spouse's subsequent death, all assets would be included in the surviving spouse's taxable estate, with the surviving spouse's estate being able to apply only the estate exemption amount of the surviving spouse.
The bypass trust allowed the predeceased spouse's estate tax exemption amount to be placed inside of the bypass trust, commonly referred to as a "family trust", which preserved it. The bypass trust assets would not be included in the surviving spouse's gross estate upon his or her death because the bypass trust owns the assets - not the surviving spouse. The bypass trust allows the surviving spouse not only to be a beneficiary, but potentially to even manage the trust by serving as its trustee.
With the concept of "permanent portability" under A TRA, the need for bypass trust planning is no longer necessary to preserve the deceased spouse's unused estate tax exemption amount. When the first spouse passes away, the personal representative of said spouse's estate would file Form 706, the estate tax return, and all of said spouse's unused estate exemption amount would pass to the surviving spouse.
With this concept of "portability", why would anyone ever use a bypass trust as part of an estate plan? There are some considerations that need to be made:
- Assets in a bypass trust appreciate in value and do not become a part of the surviving spouse's estate, regardless of the extent of the appreciation. As a result, a bypass trust may be an ideal place for assets that are likely to significantly appreciate in value, such as in a start-up company, mineral interests, and real estate in areas where an explosion in value is anticipated. For such assets passing to a surviving spouse under a portability-based plan, the appreciation in value becomes a part of his or her estate and will be subject to the estate tax exemption upon his or her death.
- Assets of a bypass trust typically are protected from the surviving spouse's future creditors.
- A surviving spouse may also remarry, and a properly drafted spendthrift provision inside of a bypass trust would protect the bypass trust assets from the new spouse's creditors.
- The bypass trust allows the deceased spouse to protect against the possibility that the surviving spouse may "redirect" said assets to a person that the deceased spouse may not wish to benefit. This may occur in "blended families" where the spouses have different ultimate remainder beneficiaries, perhaps each having children by a prior marriage. The bypass trust could preserve the deceased spouse's assets to pass as he or she intends.
- "Portability" is available only with respect to the estate tax exemption amount of the "last deceased spouse". This exemption amount could be lost if the surviving spouse remarries. The estate tax exemption amount only pertains to the "last deceased spouse". This, hypothetically, could create a problem for the surviving spouse if he or she were to remarry a wealthy person who also predeceased the surviving spouse, without having any estate tax exemption amount left.
- Inasmuch as it is required that a decedent's personal representative file a Form 706 - Federal Estate Tax Return to permit the surviving spouse to use the first spouse's unused estate tax exemption amount, i.e., to take advantage of portability, even though no estate tax is actually due, the use of the bypass trust could potentially eliminate this need for filing the return.
- Significantly wealthy people must still utilize the bypass trust to achieve generation skipping transfer (GST) tax efficiency because the GST exemption is not portable under ATRA.
With the limited list of "pros", set forth above, most assets included in the surviving spouse's estate will receive a second "step-up" in basis when the surviving spouse dies. The first step-up occurred on the death of the first spouse. However, assets inside of a bypass trust receive a step-up only on the death of the first spouse. One must compare, however, the different tax rates applicable. The estate tax rate is significantly higher than the capital gains rate so the advantage of the additional step-up must be weighed against the estate tax liability that occurs as a result of the assets being included in the surviving spouse's estate, which would not be the case if those assets were retained inside of a bypass trust.
Portability also eases dealing with retirement accounts. Now the surviving spouse can simply be named the designated beneficiary and receive the benefits without complex trust provisions.
Also, bypass trusts introduce additional administrative complications to the surviving spouse, i.e., the filing of annual tax returns, trust accounting's, etc., which the surviving spouse may wish to avoid. "Portability", and the elimination of the bypass trust, eliminates this requirement.
The bypass trust is intended to protect against wasting the predeceased spouse's estate tax exemption amount. However, most married couples who may have once needed "mandatory" bypass trust planning may no longer need it because of portability. Thus, an estate plan that allows creation of a bypass trust only with a qualified disclaimer would allow the surviving spouse to evaluate whether there are some unique reasons why the bypass trust might be advantageous and, if not, to go the "portability" route, file the estate tax return, etc .. Couples seeking to take advantage of both estate tax and GST tax planning, however, will ontinue to use the bypass trust as an important feature of their testamentary plan.