How the Lifetime Bypass Trust Works: Attention CPAs

Many of my clients are interested in the Lifetime Bypass Trust. And some are vetting the concept through their CPAs. Here is an email (with the names removed) I have sent to several CPAs to clarify this amazing but simple planning strategy.

The structure we are proposing is a lifetime bypass trust. The concept is the same as used with an A/B trust, or bypass trust.

When a bypass trust is created upon the death of a spouse, it is funded with the deceased spouse’s share of property up to the then death tax exclusion amount. The surviving spouse is usually the trustee and the primary beneficiary of the bypass trust.

The benefits of the bypass trust are:

1) Assets in it (and all future growth) will not be subject to the death tax at the deceased spouse’s death or at the surviving spouse’s death because the trust was funded using the deceased spouse’s death tax exclusion, and

2) Assets in it will be significantly protected from lawsuits and divorce claims against the surviving spouse.

The use of a bypass (A/B) trust is a tried and true estate planning strategy.

The Lifetime Bypass Trust is based on the same principal, except that we are creating and funding it now, to take advantage of the $5.12M gift exclusion available this year, rather than waiting until a spouse dies. One of my client’s calls it an “early bypass trust.”

Just like the at-death bypass trust, the lifetime bypass trust would name spouse as trustee and spouse and children as beneficiaries.

Just like the at-death bypass trust, the assets in the lifetime bypass trust would be exempt from estate tax when the grantor spouse dies, when the surviving spouse dies and, if generation skip exemption is used, even when their children die – two generations of no estate tax on the gifted asset and future appreciation.

Just like the at-death bypass trust , we can give the surviving spouse a limited power of appointment to change the remainder beneficiaries, limited to a certain class of people, like descendants. However, with the lifetime bypass trust, we could also include the grantor spouse as a permissible beneficiary. (Can’t do this with bypass trust created at death b/c the grantor spouse is dead.)

The grantor spouse, after the creation of the trust, can be named a remainder beneficiary if done correctly. This will not cause estate tax inclusion unless there is an implied understanding between grantor and trustee at the time the trust is created.

We recommend drafting the lifetime bypass trust to give an independent third party/trust advisor the authority to add and remove the grantor spouse as beneficiary.

The lifetime bypass trust uses the tried and true principles of a standard at-death bypass trust, but it uses the gift exemption now, while it is $5.12M, rather than at death, when the death tax exclusion is scheduled for a big drop (under current law $1M).

The downside to the lifetime bypass trust is the loss of step up in basis at death. But since the estate tax rate (35%-55%) has historically been a much higher rate than the capital gains tax rate (15%-20%) , most people would rather avoid the estate tax. In addition, the Democrats and the President have expressed their intent to do away with the step up in basis for inherited assets. So losing the step up in basis may happen anyway.

Finally, we may look back and realize 2012 was the best and easiest time in history to reduce or eliminate estate tax. If the estate and gift tax exclusions drop as scheduled on January 1, planning will get much more complicated and much more expensive.

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