What is a bypass trust?

A bypass trust is designed to contain property that will bypass a surviving spouse’s estate and thereby avoiding excessive estate taxes if one spouse dies. Bypass trusts are especially useful for spouses with large estates who plan to leave the remainder of their estate to children because it reduces the amount of estate taxes owed and aids in avoiding probate court.

Why Bypass Trusts Were Invented

Prior to WWII, spouses could not transfer property directly to their surviving spouse without paying estate taxes. This meant that a widow or widower was left with high estate taxes to pay for their family home and belongings at the death of the first spouse. In response to this publicly unfair practice, the federal government stepped in and established the first universal estate credit transfer. Initially, half of the total estate would transfer without taxes to the surviving spouse, leaving the other half with tax liability attached. After 1980, this law finally changed to permit a 100% transfer between spouses for both gifts while alive and through wills and trusts once one spouse was deceased.

This new law spawned a legal response of direct transfer wills a trusts allowing property to be transferred, utilized, and controlled by the surviving spouse without the fear of excessive taxes. However, this also caused a greater expense for any surviving children once the second spouse died. So while the widow or widower experience little tax consequences, the children had a high tax burden.

Modern tax law kept evolving and began allowing a set annual exclusion amount for estate taxes. This annual exclusion allowed smaller estates to avoid estate taxes completely, and larger estates a means of avoiding some tax liability. This annual exclusion amount became the reason for creating bypass trusts.

Advantages and Disadvantages of a Bypass Trust

A bypass trust, as part of an AB trust plan, is a trust that controls the flow of a couple’s estate into two separate portions. The first portion is a gifted amount given to the children in the amount of the annual exclusion. This allows a portion of the couple’s estate to be given away without any tax consequences to the children. The second part of the bypass trust is the remaining estate. This portion is given directly to the surviving spouse for their use and distribution.

A bypass trust allows a couple’s large estate to be reduced by the annual exclusion amount without any tax consequences. It also ensures a smooth transition for the surviving spouse by allowing them to avoid both probate court and estate taxes. Also, a bypass trust is available to non-citizen spouses, unlike a direct transfer will, which is only allowed for citizens.

As great as this trust sounds, there are some disadvantages. First, it’s more complex to create than a simple will or even a basic trust, which means you will be paying more to your estate planning attorney. Secondly, a simple bypass trust could still overload the surviving spouse’s estate causing higher estate taxes for the children.

Case Studies: Bypass Trusts in Estate Planning

Case Study 1: The Anderson Family

Mr. and Mrs. Anderson, a wealthy couple in their late 60s, have built a substantial estate over the years. They are concerned about the potential estate taxes their children would have to pay upon their passing. Seeking a solution, they consult an estate planning attorney who recommends setting up a bypass trust as part of their AB trust plan.

By doing so, they can take advantage of the annual exclusion amount, gifting a portion of their estate tax-free to their children while securing the remaining assets for the surviving spouse. With the bypass trust in place, the Andersons can ensure a smooth and tax-efficient transfer of wealth to the next generation, providing financial security for their loved ones.

Case Study 2: The Ramirez Estate

Mr. Ramirez, a successful businessman, married Mrs. Ramirez, a non-citizen spouse originally from a different country. As they plan their estate, they discover the complications that arise due to their different citizenship status. Their attorney suggests creating a bypass trust to address this issue.

By setting up the trust, they can structure their estate plan to minimize estate taxes and ensure that assets pass smoothly to the surviving spouse and, eventually, to their children. The bypass trust proves to be a vital tool for the Ramirez family to navigate the complexities of estate taxation and maintain control over the distribution of their wealth across international borders.

Case Study 3: The Lewis Legacy

The Lewis family is a well-known philanthropic family with significant assets. They have a long-standing commitment to supporting various charitable causes. To continue their legacy of giving, they consider establishing a bypass trust as part of their estate plan.

This trust will allow them to pass a portion of their estate tax-free to their children while dedicating the remaining assets to a charitable foundation. By doing so, the Lewis family can minimize estate taxes, provide for their children’s financial security, and create a lasting impact through their philanthropic efforts.

Getting Legal Help

If you are considering a bypass trust for your estate, it’s important that you contact an estate planning attorney to set up a consultation and find out if this type of trust is the best option for your estate planning needs.