For more than a decade, a common estate planning approach has been to bequeath a couple's assets up to the amount of the federal or state estate-tax exemption to a bypass trust after the first spouse dies, leaving the remaining assets outright to the surviving spouse (or to some form of a marital trust). Later, upon the death of the surviving spouse, assets within the bypass trust would go directly to the children, bypassing the surviving spouse's estate and thereby saving estate taxes.
But new rules have changed many aspects of trust planning. The details governing bypass trusts have become more complex in the wake of this year's tax law changes. At the same time, these trusts may offer the chance of even greater overall tax savings.
There are a number of elements to consider, both when lawyers are creating trusts for your clients and when you are investing assets for a trust.
Start with the most basic decision: The traditional bypass trust named only the surviving spouse as current beneficiary - that is, the person who could receive distributions. This status is distinguished from the remainder beneficiaries, who receive distributions only after the second spouse dies.
Now, however, the income tax system has assumed a more aggressive posture, and a smarter bypass trust can be created to optimize a family's overall tax position. The opportunity is to help the family save the most overall, whether in estate taxes or income taxes. This lets the bypass trust serve as an annual income tax savings tool.
Generally, income tax laws incorporate a concept referred to as the "assignment of income doctrine." If you earn a salary, you cannot hand a paycheck to your child and let her report it at her lower tax bracket. It's your income: You earned it; you have to pay the income tax on it.
But trusts are an exception to this rule. A trust can distribute income it earns to any beneficiary, who will then report the income on his or her tax return. If a trust has a laundry list of family members as current beneficiaries, the trustee can decide each December which ones are in the lowest income tax brackets and make distributions to those beneficiaries. Each year, the evaluation can begin anew. That's almost tax nirvana.
Within a bypass trust, therefore, a key is to name surviving spouse and all descendants - not just the surviving spouse - as current beneficiaries.
The boilerplate language of most bypass trusts provides instructions for how the trust should be invested. Often, this includes a mandate that modern portfolio theory be adhered to. Now, however, that seemingly sound approach could actually prove quite detrimental.
Rather, the language should be broad enough that it does not restrict optimal asset location decisions - specifically with regard to holding some types of assets within the bypass trust and others in the surviving spouse's name.
Historically, equities were held in the bypass trust to maximize the growth outside the client's estate. In light of the higher capital gains rates enacted as part of the tax deal by lawmakers early this year, however, the opposite approach may now be optimal for some clients.
Assets held in the surviving spouse's estate will have their income tax basis "stepped up" on that spouse's death, so the tax basis of the assets that have increased in value will rise to the fair market value at the time of death. In short, this eliminates any capital gains that occurred before death.
But since they are outside the surviving spouse's estate, assets in a bypass trust don't qualify for a basis step-up. In many cases, it might make sense to have bonds (or their equivalent) held in the bypass trust, and equities in the surviving spouse's name.
Flexibility in making such decisions might be especially beneficial in optimizing overall tax saving. So you might make the mandate to adhere to modern portfolio theory suggestive rather than mandatory, for instance, or include permission for the trustees to consider its application on a familywide basis.
POWERS OF APPOINTMENT
A power of appointment - the right given to a person to determine who gets trust assets - is a common feature of many trusts. In the case of a bypass trust, the surviving spouse could be given the right to decide how the assets in the bypass trust should be divided among the surviving children, for example, or whether they should be distributed outright or held in trust.
There are two broad types of powers of appointments in the tax world. Limited powers of appointment give the holder the right to appoint assets, but because the right is limited, the power does not cause assets to be included in that person's estate. The second type is a general power of appointment, which causes the assets subject to the power to be included in the holder's estate.
What if the bypass trust language gave the surviving spouse a general power of appointment over any assets that have appreciated more than, say, 20%? That could shift those assets into the holder's estate and qualify them for the coveted basis step-up on death.
Distribution provisions in a traditional bypass trust directed the surviving spouse to get income and perhaps certain rights to invade principal. New trusts can do better.
In deciding how much to distribute to beneficiaries, clients may also want assets removed from the bypass trust and included in the surviving spouse's estate to get a step-up in income tax basis on the second spouse's death. The trustee could be given the right to distribute outright to the surviving spouse any assets that have had a substantial appreciation (20% in the example cited). Below this threshold, assets remain snug in the bypass trust, free of estate tax; above it, assets can be distributed to the surviving spouse and included in his or her estate, qualifying for a step-up.
Most traditional trusts did not include provisions permitting a trust to relocate to a new state. But if the state where the trust is administered can be changed, future state income taxes may be minimized.
For example, if the husband dies in a state with a costly tax system, the bypass trust will be established under his will in that state. But if, years later, the wife as the primary beneficiary of the bypass trust moves permanently to a state with no income or estate tax, it would be helpful to have the trust move with her.
In many instances, adding this type of flexibility when the bypass trust is created might prove to be a huge help later on.
Bypass trusts will remain a common fixture of estate plans for wealthy clients - even many below the federal estate-tax threshold. In assuring that clients are properly protected and that financial advisors have the maximum latitude to best administer the bypass trust once it is funded, the key is to assure that the trust is drafted with more flexibility than most bypass trusts traditionally have been. Proactive planners can assure a better result for their clients.
Martin M. Shenkman, CPA, PFS, JD, is a Financial Planning contributing writer and an estate planner in Paramus, N.J. He runs laweasy.com, a free legal website.