Couples with modest assets who have older trusts may have imposed restrictions on themselves that no longer make sense under current tax law.
If married couples own substantial assets (currently $10 million together, but the law may change), they still may be able to reduce federal estate taxes by having a living trust that divides their assets into separately taxable sub-trusts after the first member of the couple passes away. However, for married people who own less than $10 million together, this type of division should no longer be mandatory because it imposes a burden of restrictions and paperwork on the surviving spouse that will not necessarily create a tax advantage.
This page mainly discusses the differences between "A-B" or "bypass" trusts for couples, and the newer, more flexible "disclaimer" trusts. For a more general introduction to revocable living trusts, see our "Trusts vs. Wills" page.
Warning for Couples with Older Bypass or A-B Trusts
Married couples with older trusts should seriously consider having them redrafted. Trusts written for couples before the federal tax law changes of 2001 may contain restrictions that are no longer necessary. In particular they may overly limit the surviving spouse’s access to assets in the estate after the first spouse passes away. If you have an older trust it may be a bypass trust, also known as an A-B or “B” trust, credit shelter trust, credit shelter exemption trust, exemption trust, credit trust, or nonmarital trust.
Bypass trusts drafted before the early years of this decade are now inappropriate for many middle-income people. The trouble is, bypass trusts create an inflexible requirement to divide an estate into separate parts when one spouse passes away. The trust usually divides the household assets at the time of the first spouse’s death, to create a “survivor’s trust” to hold assets for the surviving spouse, and a "bypass trust" to hold the deceased spouse's part of the assets. The surviving spouse has full and complete access to the survivor’s trust and receives income from the bypass trust. However, the bypass trust is usually intended primarily to benefit the beneficiaries of the deceased spouse. That is, typically the surviving spouse receives interest, rent or dividends from the bypass trust property but is essentially a caretaker of the underlying property on behalf of the couple’s children or others who will inherit it after the surviving spouse's death.
Typically, the surviving spouse has very limited access to the principal of the bypass trust. The disadvantages of bypass trusts are:
1) The surviving spouse may not have full control over enough money to comfortably sustain his or her standard of living;
2) bypass trusts are no longer necessary as a tax saving device for married couples with less than about $2 million in
assets, and
3) Bypass trusts may cause unnecessary complications and expenses for the spouse who survives.
Advantages of Disclaimer Trusts
As an alternative to the bypass trust, the disclaimer trusts we prepare do not force the estate to be split when one spouse passes away. In contrast to bypass trusts, disclaimer trusts give the surviving spouse the option to split the trust, in whatever proportion he or she chooses, only if it is necessary to save taxes. Disclaimer trusts offer maximum flexibility where each spouse wishes the other to keep the household's combined property after the first spouse passes away. If you already have a bypass trust and you have a moderate-sized estate (less than $10 million), you may wish to consider having your trust changed from a bypass to a disclaimer trust, or you may need to have your bypass trust revised for greater flexibility. This section describes changes in the federal estate and gift tax laws and provides a comparison between bypass trusts and disclaimer trusts.
Tax Reasons for Married Couples to Have a Trust
If a married couple’s estate exceeds federal tax thresholds, a trust may help them leave property to family members or others without paying high estate taxes. The estate tax applicable exclusion amount, which applies to inheritance at death rather than gifts during life, is different and changes periodically.
At the very end of 2010, Congress raised the federal exemption amount (called the applicable exclusion amount) for estate taxes to $5 million in 2011. Previous tax law had provided for this threshold to drop back to $1 million in 2011.
The $5 million applicable exclusion amount is of particular importance for members of married couples. For a married couple, if both are U.S. citizens, there is generally no immediately payable tax upon the death of the first spouse, to the extent the first spouse leaves property to the surviving spouse. However, when the surviving spouse also dies, if the surviving spouse’s estate contains more than the estate tax applicable exclusion amount, then federal taxes of up to 45% may apply to assets above the exclusion amount.
Although the surviving spouse may be protected against an immediate tax at the time of the first death, couples who did not take care of estate planning before the first death can lose the advantage of the first spouse’s $5 million exemption, with consequences that are postponed until after the second death. The unlimited marital deduction allows U.S. citizen spouses to pass unlimited assets to each other upon death, without taxes. However, if one spouse dies without advance estate planning, the couple has lost the use of that spouse’s estate tax applicable exclusion amount. That missed opportunity can leave the surviving spouse with a too-large estate resulting in an unnecessarily high tax debt for the couple’s heirs. For single people who pass away in 2011 and own more than $5 million in real estate or other assets, every dollar over $5 million will be taxed.
Example 1:
The Applicable Exclusion Amount for an Individual
If a single person were to pass away in 2011, without having made any large gifts during life, he or she could leave an estate worth up to $5 million without incurring federal estate taxes. However, if the same person died leaving $5.1 million in assets, then that person's heirs would have to pay federal estate taxes on $100,000 – the amount in the estate beyond $5.1 million.
Example 2:
Tax Implications of No Estate Planning
Bill and Jane, who are both U.S. citizens, have $7 million in community property assets. Bill dies in 2011, leaving Jane his entire estate. Because of the unlimited marital deduction, Jane does not owe federal estate taxes at the time of Bill’s death. Jane dies later in 2011, leaving the $7 million estate. Since the estate tax applicable exclusion amount for 2011 is $5 million, Jane’s heirs have to pay estate taxes on $2 million. If the couple had done some estate planning, they could have eliminated the need to pay this tax.
Changes in the Federal Estate and Gift Tax Law
Federal estate and gift tax levels are in flux. The Economic Growth and Tax Relief Reconciliation Act of 2001 temporarily phased out the estate tax but retained the gift tax. When the applicable exclusion amount was set to fall to $1 million in 2011, Congress acted to raise it to $5 million, but it is not clear whether Congress might act again to change it in the future.
Gifts during a donor's lifetime may also face federal taxation. In each year 2009 through 2011, an individual has been allowed to give away $13,000 to each of an unlimited number of recipients without gift tax liability and without having to file a gift tax return. However, gifts above $13,000 per person begin to eat into the $5 million lifetime gift tax exemption. Any gift exceeding the $13,000 limit reduces the donor's ability to give tax-free inheritances. For example, if I gave my friend $23,000 today and I passed away during 2011, my estate would be allowed to convey a further $4,990,000 free of estate and gift taxes, rather than the usual 2011 limit of $5 million, because the $23,000 gift was $10,000 beyond the allowable annual limit. (For more information see the helpful IRS primer, "Frequently Asked Questions on Gift Taxes.")
Bypass or A-B Trusts
As we’ve explained, bypass or A-B trusts divide after the first spouse's death into a survivor's trust and a bypass trust. The survivor’s trust is usually a revocable trust, which means the survivor may rewrite it in any way, or may revoke it entirely and take direct ownership of its assets. The revocable survivor’s trust is therefore treated as the survivor’s personal property for tax purposes. By contrast, the bypass trust becomes irrevocable (unchangeable) when the first spouse passes away. Typically, then, the surviving spouse receives income from the bypass trust but has restricted access to the principal of the bypass trust. The deceased spouse’s beneficiaries receive the principal of the bypass trust once the surviving spouse has passed away. Because the bypass trust for the deceased settlor is irrevocable and hence beyond the surviving spouse's complete control, it is not considered to belong to the surviving spouse for federal tax purposes. Hence at the second spouse's death, no estate tax is imposed on the bypass trust. This is why the bypass trust can reduce or even eliminate estate taxes for married couples.
The choice of a bypass trust would make effective but inflexible use of the $5 million federal estate tax exemption of the first spouse to die. Without it, the couple would lose the advantage of the decedent’s $5 million estate tax applicable exclusion amount. Here are a couple of examples showing how bypass trusts can help married couples, but also how they can interfere with surviving spouses’ access to their savings.
Example 3:
Use of a Bypass Trust to Reduce Federal Estate Tax
Bill and Jane have $7 million in community property assets. Their bypass trust provides for half the estate to pour into the bypass trust upon the first spouse’s death, while half
the estate remains in the hands of the surviving spouse. Bill passes away in 2011. $3.5 million funds the bypass trust for Bill’s heirs and $3.5 million goes to a “survivor’s trust” for Jane. Jane is free to use the $3.5 million in her survivor’s trust as she pleases. Jane receives the income from Bill’s bypass trust, but will have limited access to the principal in the bypass trust.
The following diagram illustrates the split in trust funds:
↓
| $3.5 million irrevocable bypass trust for deceased spouse (Bill) |
$3.5 million survivor's trust for surviving spouse (Jane) |
If Jane passes away later in 2011, Jane’s heirs inherit the $3.5 million in Jane’s survivor’s trust, while Bill’s heirs inherit the $3.5 million in Bill’s bypass trust. No federal estate tax is due.
Example 4:
Problems of a Bypass Trust
Suppose Bill and Jane have set up a bypass trust as before, but in this example their estate is smaller -- say, $1.5 million. In 2011, after Bill passes away, Jane wants to move to a smaller home and visit distant relatives often.
The family home is worth $750,000. If the house goes into Jane's survivor's trust, and the other assets go into Bill's bypass trust, then she will only have access to the income from the bypass trust assets, plus very limited access to the principal (typical older trusts contained a "five by five" provision allowing the widow to collect five percent of the bypass trust principal or $5000 each year). If this is the case, she will have to live relatively modestly.
If Jane is well advised, and if the trust allows her to do so, she will use the assets represented by the home to make up the value that the trust requires to be placed into Bill's bypass trust. The rest of the couple's assets can then be under Jane's full control in Jane’s survivor’s trust. In such a case, if Jane chooses to sell the house that is in the bypass trust, she will be able to collect income from the proceeds of the sale and (depending on the trust's provisions) she may be able to live in a home purchased with part of the proceeds. However, she still may have limited access to the principal. She may have to count on supplying her lifelong daily budget from her half of the couple's assets.
Several years ago, it made sense for many middle-income people to have bypass trusts drafted in order to save their heirs from paying federal estate taxes. However, older couples who own less than about $3 or 4 million, whose assets are invested conservatively (that is, most people) should probably not have a bypass trust if their only objective is to avoid paying estate taxes. (On the other hand, one advantage of bypass trusts is that each spouse can ensure that the surviving spouse will not disinherit the deceased spouse’s heirs. This type of trust is particularly useful if one spouse has children from a previous marriage.)
Disclaimer trusts, however, can temper the inflexibility of bypass trusts.
Disclaimer Trusts
Disclaimer trusts can shift assets in response to changing estate tax thresholds and household financial needs. In a disclaimer trust, each spouse leaves his or her share of the estate completely to the surviving spouse. After the first spouse passes away, the surviving spouse holds the power to decide, within nine months after the death, whether the assets should be split.
The survivor may choose to keep the whole estate in a revocable Survivor’s Trust, which makes everything taxable under the survivor’s own Social Security Number. Alternatively, the survivor may “disclaim” some assets so they will flow into a disclaimer trust, potentially reducing federal estate taxes. The disclaimer trust, if created, is structured like a bypass trust in that the surviving spouse receives income from the disclaimer trust, cannot revoke it, has little or no power to change it, and has limited access to its principal. (These separations are still necessary for the
disclaimer trust to receive separate tax treatment from the survivor's own property.)
The primary difference between a disclaimer trust and a bypass trust is that, with the disclaimer trust, the surviving spouse still has power after the first death to decide which if any assets to place into the disclaimer trust. The surviving spouse can fund the disclaimer trust only as much as makes sense in light of the federal estate tax structure and the value of assets remaining after the first death. The surviving spouse is not forced to place assets into a disclaimer trust based on assumptions possibly made years before when tax rules were different.
A disclaimer trust does require a high degree of trust between spouses because it gives the widow or widower full control over the assets after the first death, including the right to change the estate plan entirely. In other words, the disclaimer trust does not guarantee any share of the estate to the deceased spouse’s heirs or named beneficiaries. However, if both spouses trust that each will not disinherit the other’s heirs or beneficiaries, then the disclaimer trust is an attractive alternative to the bypass trust.
Couples should also consider that the disclaimer trust form requires relatively quick action from the surviving spouse, which can be difficult during the grief process. If the disclaimer trust is to be funded at all, the survivor must take care of the necessary decisions and paperwork within nine months after the first spouse passes away.
Example 5:
The Flexibility of a Disclaimer Trust
Returning to Bill and Jane and their $1.5 million community property estate, let’s again assume Bill passes away in 2011, but now the couple has a disclaimer trust rather than a
bypass trust. Bill leaves his share of the estate to Jane. The applicable exclusion amount in 2011 is $5 million. No tax is due at Bill’s death because of the unlimited marital deduction. Jane chooses not to fund the disclaimer trust because she believes Congress will not reduce the applicable exclusion amount enough to matter for her asset level. If the exclusion amount does not fall before Jane's death, her estate will pay no federal tax.
On the other hand , suppose Bill and Jane had a larger estate, or Jane makes a successful investment, and as of Bill's death the estate is $7 million. In that case, within nine months of Bill's death, Jane could "disclaim" $2 million of the estate, allowing it to flow into the "disclaimer trust." Her access to this $2 million would be very restricted, but her own $5 million survivor's trust would provide amply for her own needs, and meanwhile the $2 million would be set aside for her heirs with a lower risk of estate tax.
In these examples, the flexibility of a disclaimer trust rather than a bypass trust creates significant advantages for Bill and Jane. As with the bypass trust, the surviving spouse (Jane) can use the exemption of the deceased spouse (Bill) if the couple created a disclaimer trust while both were living. But instead of being forced to put money in a bypass trust when the first spouse passes away, the surviving spouse has the option of funding the disclaimer trust at a level that makes sense in light of the tax implications. The surviving spouse can therefore use the entire estate to travel, buy another home, give gifts to loved ones, donate money to charity, etc.
As we mentioned above, if you had a bypass trust drafted before the early 2000’s you may wish to consult an attorney to determine whether it is still the right type of trust for you. If you would like to meet with us, the initial half-hour consultation in preparation for an estate plan is free of charge.
