This article has been reviewed by a practicing attorney in 2020
This content is not intended to be a substitute for professional legal advice. Always seek the advice of an attorney or another qualified legal professional with any questions you may have regarding your situation.
As discussed in previous articles, creating a comprehensive estate plan tailored to your family’s circumstances is an important step in managing your wealth and ensuring that your family is provided for once you have passed. We have highlighted different avenues available for distributing your estate after your death, including a will, revocable and irrevocable trusts, and more specific trusts such as the Crummey trust. This article focuses on another type of trust: the bypass trust. The bypass trust may be advantageous to married couples with substantial assets or couples who are married but also have children from previous relationships.
Common Trust Provisions
Before explaining the specific terms of a bypass trust, it is first important to understand common trust provisions. It may be beneficial to review our article on trusts, so you have a basic understanding of what a trust is and how it operates.
All trusts include three categories of people, institutions, or entities that are involved in its creation, management, and distribution:
- Grantor: the person who creates the trust and transfers his or her assets into the trust
- Trustee: the person or institution who manages the trust assets and property
- Beneficiary: the individual or entity who receives the trust’s “benefit”
Trusts typically fall into two categories: revocable and irrevocable. In a revocable trust, the grantor may freely modify, alter, amend, revoke, or cancel the terms of the trust or the trust itself during his or her lifetime. Contrastingly, an irrevocable trust is one that cannot be changed or modified once it has been created. Even though the grantor may still be living, the irrevocable trust generally remains irreversible, and its terms, including its designated beneficiaries and how to distribute trust property to them, cannot be altered. There are a few exceptions to this rule. Some state laws allow for judicial intervention to change the terms of an irrevocable trust in limited circumstances. Further, some irrevocable trusts may be altered if all beneficiaries to the trust agree to change the terms.
What is a Bypass Trust?
To form a bypass trust, also called an AB trust, generally, an individual’s will instructs that two separate trusts are formed on his or her death. The first trust created is the “A” or “marital” trust. The second trust is the “B” or “bypass” (may also be called “family”) trust. The decedent spouse’s assets transfer to these trusts tax free.
The marital trust is a revocable trust that holds assets for the surviving spouse. Because this trust is revocable, the surviving spouse has complete control over it, and they can sell, spend, or give away assets however they please.
Contrastingly, the bypass trust is an irrevocable trust that likely holds any high value assets as inheritance for beneficiaries. Because this trust is irrevocable, the surviving spouse has no control over it. Further, the surviving spouse no longer has access to any assets that were transferred into the bypass trust. However, depending on the terms of the trust, the surviving spouse may be entitled to receive trust income from the bypass trust during his or her lifetime (usually for the purposes of health, education, support, or maintenance).
The surviving spouse may act as trustee over the bypass trust. The trustee is charged with ensuring that assets from the decedent’s estate are appropriately distributed to each trust. It is also the trustee’s responsibility to oversee asset management, as outlined by the terms of the trust. If the assets within the bypass trust are substantial and complicated, it may be difficult for the surviving spouse to manage. Accordingly, the surviving spouse may elect to name someone else as trustee of the bypass trust. When the surviving spouse dies, all assets in the bypass trust are transferred to the beneficiaries, bypassing any federal estate tax liability.
Benefits of Bypass Trust
As alluded to above, a bypass trust may be beneficial to married couples with a large estate because it can help them avoid federal estate taxes on certain assets when one spouse dies. However, only estates valued over $11.58 million in 2020, and $11.7 million in 2021, are subject to the federal estate tax. Therefore, generally, only very affluential couples whose estate is valued over the limits above need worry about the federal estate tax.
However, some individuals well under the estate tax limit may still find bypass trusts beneficial for their circumstances. If one or both of the married couple have children from a previous relationship, the bypass trust can help ensure that the child from the previous relationship receives an inheritance by naming him or her as a beneficiary under the bypass trust.
Ex. 1: Ashley and Ben have three children, Carl, Dan, and Elise. Ashley and Ben’s estate totals over $20 million. Ben’s will provides for the creation of a bypass trust upon his death. The bypass trust lists the couple’s three children as beneficiaries. Upon Ben’s death, the couple’s primary residence, joint checking, and joint savings account are transferred into the marital trust. As the trustee and sole beneficiary, Ashley has the freedom to live in the residence, and use the funds from the couple’s joint checking and savings accounts in whatever manner she sees fit.
The remainder of Ben’s estate, including other real estate and investments are transferred into the bypass trust. Because the bypass trust is irrevocable, generally, Ashley cannot reach the real estate or other investments within the trust. Rather, the trust owns these assets and holds them for the beneficiaries. When Ashley dies, Carl, Dan, and Elise receive the bypass trust assets and are shielded from the estate tax.
Ex. 2: Ashley and Ben married in 2010. Ben has one child, Carl, from a previous relationship, and Ashley has two children, Dan and Elise, also from a previous relationship. Ben’s estate totals around $1 million. Ben has created a will, which provides for the creation of a bypass trust upon his death. The bypass trust lists only Carl as beneficiary. Ben dies in 2015. In accordance with the terms of the bypass trust, the couple’s marital residence as well as their joint checking and savings accounts are transferred to the marital trust for Ashley’s benefit. The remainder of Ben’s estate, namely real estate investments, is transferred to the bypass trust. After Ben’s death, Carl becomes estranged from his stepmother Ashley, and his stepsiblings Dan and Elise. Resenting such estrangement, Ashley wants to cut Carl off from receiving his inheritance from Ben, instead desiring to take the estate herself and leave the remainder of Ben’s estate to her two children, Dan and Elise. However, because the remainder of Ben’s estate was transferred to the irrevocable trust, which named only Carl as beneficiary, Ashley cannot prevent Carl from inheriting his portion of Ben’s estate.
When Bypass Trust is Not Funded
While funding a bypass trust is mandatory after one spouse dies, issues may arise when a surviving spouse ignores this provision or refuses to follow it. Continuing with the example, above, upon Ben’s death, Ashley objected to Carl receiving any of Dan’s estate. As such, she refused to fund the bypass trust with Ben’s assets. Because funding a bypass trust is a mandatory requirement, Carl has the right to sue Ashley to enforce the creation and funding of the bypass trust. Dan could even sue Ashley’s estate after her death to recoup any assets that should have been transferred to the bypass trust.
Potential Negative Consequences
Unless one of the two examples above apply to you, bypass trusts may cost you more than they are worth. As an initial matter, this type of trust can be quite complicated to set up, and it would be wise to enlist the services of an estate planning or tax attorney to help draft it, which could be costly. Further, these types of trusts often require ongoing maintenance, such as directing trust assets, keeping proper records concerning how trust assets are managed, and reporting an accounting of trust assets to beneficiaries. This can also become expensive if the surviving spouse names someone else as trustee because a trustee is entitled to a fee for their services.
It is also important to understand that, even if a bypass trust helps avoid federal estate taxes, the estate may still be liable for state estate taxes. Further, keeping the bypass trust may result in the irrevocable trust incurring unnecessary capital gains tax, which could result in the trust beneficiaries paying more in taxes than they would have if the bypass trust had not been created.
Consulting a Professional
Creating any type of trust can have substantial tax consequences. If you are considering creating a trust as part of your estate plan, it is recommended that you consult an estate planning attorney, financial advisor, or both, to help create the best plan for you and your loved ones.