Posts Tagged ‘credit shelter trusts’

Weighing Estate Tax “Portability” Against the Bypass Trust

NOVEMBER 9, 2015 VOLUME 22 NUMBER 41

Here’s a challenging problem for lawyers who focus on estate planning: how can we explain federal estate tax “portability” to clients in a way that helps them figure out how the concept applies to them? After five years of experience with the idea, you might expect us (collectively) to be better at this.

When Congress introduced the idea of estate tax portability in 2010, it was partly to simplify estate tax planning. In the decades before that development estate planners regularly found themselves explaining the idea of a “bypass” trust — although some favored “credit shelter” or “exemption equivalent” or “A/B” or “decedent’s” rather than “bypass.”

The bypass trust idea was not all that complicated, but it was not intuitive. First, it was only important for married couples. Second, it was much more important for couples with a taxable estate — though that included a lot more people twenty years ago than it does today. For married couples worth more than the estate tax exemption amount, though, the bypass trust was almost universal.

Here’s the basic idea: when one spouse dies, his or her share of assets subject to the estate tax — up to the amount of the estate tax exemption in place at the time of death — could be put into a trust that was treated as taxable. Since the amount going into the trust would be less than the tax limit, the amount of tax would be $0. That money would then not be taxed in the surviving spouse’s estate when she or he later died. It was fairly easy to double the estate tax exemption amount, in most cases, using the bypass trust.

Now “portability” makes that planning moot — or it seems like it might, anyway. When a spouse dies under the new rules, any unused estate tax exemption equivalent figure is passed on to his or her surviving spouse. It’s brilliantly simple in concept, but a little harder to apply in the real world (as it turns out).

Let’s consider an imaginary couple under the new portability rules. We’ll call them Dick and Jane, and they are worth a total of $8 million. Their estate plans simply leave everything to each other. When Dick dies in 2016, his $4 million (we’re going to keep Dick and Jane simple — they own every single asset jointly, with a 50/50 interest) simply passes to Jane outright. It won’t matter, for our purposes, whether that happens by his will, by the operation of joint tenancy, or by the terms of their trust or trusts.

Dick has used none of his $5.45 million estate tax exemption equivalent (that’s the new number for next year, if you didn’t already know it). Jane inherits his $4 million AND his $5.45 million in unused exemption amount. If her estate grows before her death, she still won’t owe any estate tax — even though she will be worth more than the $5 million adjusted-for-inflation figure in the year of her death.

Under the old rules, Dick and Jane would have needed to pay someone to prepare their bypass trust plan, Jane would need to actually divide the trust assets on Dick’s death, and Jane would need to give accounting information to Dick and Jane’s children for the rest of her life, while also filing separate income tax returns for the bypass trust. What a nuisance — and good riddance.

But wait. There are still times when the bypass trust is important to consider. Why? Because there are some limitations in the use of portability. Those limitations include:

  • The need to file an estate tax return. Jane can’t elect the portability option after Dick’s death unless she files a federal estate tax return — it’s a nuisance and an expense. She’ll need to get at least some valuation information for all their assets, even though no tax will be due.
  • State estate taxes. Arizona doesn’t apply an estate tax, and if Dick and Jane lived here, Jane decides to stay, and they own no assets in other states, then Jane won’t much care about state estate taxes. But what if she plans on moving, or they own a summer cottage in a state with an estate tax, or there is some other reason to worry about state taxes? Sometimes the bypass trust might be a better option.
  • Future changes in the law. It seems unlikely that estate tax levels will drop below the current $5 million plus. But then it seemed unlikely that they would go up to $5 million, too — and yet they did. Future tax rates might change, or portability might even be done away with. The bypass trust option locks in Dick’s estate tax status as against those possible changes.
  • Generation-skipping tax. If Dick and Jane intend to leave the bulk of their estate to grandchildren rather than children, or in trust for children and ultimately to grandchildren, they might want to rethink relying on portability. Why? Because the $5.45 million (in 2016) generation-skipping tax exemption does not have a portability feature. It’s unlikely to affect Dick and Jane, but it might — if they really plan on leaving much of their estates to the grandkids (and that could change over time, as the children age and gain wealth during the rest of Jane’s life).
  • Assurance of inheritance. Are both Dick and Jane completely comfortable with the surviving spouse’s ability to decide to leave most or all of their combined wealth to someone outside the family? If Dick simply leaves everything to Jane, he’s trusting that she won’t have a second family, or a big interest in a charity that Dick doesn’t actually care for, or a good friend who ends up receiving some or all of their wealth. Maybe Dick and Jane aren’t worried about this problem, but maybe they are — at least a little bit.
  • Growing wealth. Jane likely won’t add another $2 million or more to her wealth after Dick’s death — but she might. If she does, that could subject assets to the estate tax, and creating a bypass trust could have possibly avoided that eventuality.

Portability is a great boon to couples with straightforward estate plans and estates well under twice the taxable level. But it’s not a panacea, and it just makes the explanation process more complicated for us when we talk with couples about their estate planning. We hope this outline of the issues helps speed up that process.

Different Types of Trusts for Different Purposes

JANUARY 17, 2011 VOLUME 18 NUMBER 2
We frequently are asked to explain the differences between different types of trusts, or to analyze a trust with no more information than its type. Confusion about the differences is widespread, and we hope to provide a little clarity to consideration of trust types.

Before we embark, we have three caveats:

  1. We are not trying to list every possible type of trust here, but just those our clients most often encounter. We may expand this list over time.
  2. Just because you believe your trust is, for example, a “spendthrift” trust does not necessarily make it so. Even if the name of the trust includes one of these categories, it might be inaccurate. The type of trust is determined by the language of the trust itself, and it may take some close reading to identify a trust’s correct categorization.
  3. Most of these categories are neither magical nor exclusive. Just because we can categorize a given trust as a “spendthrift” trust, for example, it does not necessarily mean that it will be protected against all of the beneficiary’s creditors. And just because a trust is a “spendthrift” trust does not mean it could not also be a “special needs” trust, a “bypass” trust or some other category.

With that out of the way, let’s get started on a partial list of common types of trusts you might encounter (or create):

Spendthrift trust. This trust is protected against the creditors of a beneficiary. The trustee can not be compelled to make distributions to a beneficiary, or to the beneficiary’s creditors. This does not necessarily mean that the trustee is not permitted to make such distributions (after all, it might be in the beneficiary’s best interests to pay his or her debts). Even very strong spendthrift language might not be effective against some types of creditors in some states. Common exceptions adopted by state law include child support and alimony obligations or governmental debts. State laws vary widely on these lists.

“Third-Party” Special Needs trust. These trusts are usually specialized spendthrift trusts created for a beneficiary who suffers from a disability. The language of the trust will usually include a clear expression of the intent that the trust’s monies should not interfere (or not interfere too much) with the beneficiary’s public benefits, like Supplemental Security Income or Medicaid. The variation here from state to state, and from beneficiary to beneficiary, can be tremendous, so be very careful about generalizing when discussing third-party special needs trusts.

“Self-Settled” Special Needs trusts. Just to keep the confusion level high, there are also special needs trusts created by the beneficiary himself or herself. Of course, a beneficiary with a disability may have to act through a court proceeding, a guardianship or conservatorship, or a parent or grandparent. But whoever signs the actual documents, if the money in a special needs trust comes from the beneficiary’s own resources (like a personal injury settlement, or an unrestricted inheritance) then the special needs trust will be treated as a self-settled trust. That means the rules will be more difficult, both as to creation and administration of the trust. Can a self-settled special needs trust also be a spendthrift trust? What an interesting question you ask.

Bypass trust. Sometimes these trusts are called “credit shelter,” “exemption,” “decedent’s,” or just “B” trusts, but all of those names are pretty much interchangeable. The basic premise of a bypass trust is that a married couple arranges to take full advantage of the federal estate tax exemption amount, so that they can pass up to twice that amount to their heirs on the second death. That means that on the first spouse’s death a portion of the couple’s assets transfers to the bypass trust irrevocably, with some limitations on the use of the money during the surviving spouse’s life.

Bypass trusts are a special breed just now. Because the new federal estate tax law allows a married couple to retain both estate tax exemption amounts without having to create a bypass trust, there are a lot of trusts out there that may not still be needed. If both spouses are still alive it may be time to change the documents. If one spouse has already died the problems are more complicated. About the time we all figure this out (in two years) the estate tax provisions are scheduled to end automatically. We will have to wait most of those two years to find out if bypass trusts will fade out of existence.

Revocable trusts. Any trust that can be revoked — by anyone, but usually by the person who established the trust — is “revocable.” You may sometimes see the phrase “revocable living trust,” which means the same thing. If the only person who can revoke the trust has died (or become permanently incapacitated) then the trust has become irrevocable. Even if the name of the trust includes the word “revocable” (as, for instance, “The Smith Family Revocable Trust”) it may now be irrevocable.

Irrevocable trusts. The flip side of a revocable trust is, obviously, an irrevocable trust. The category just means that no one has the power to revoke the trust. That does not mean it will go on forever — if the assets held by the trust are spent or distributed, it ceases to exist even though it was irrevocable.

Grantor trusts. This term is most important in considering federal income tax liabilities, but it is often used more broadly. In a nutshell, a grantor trust is one in which the person who established the trust has retained one or more of the elements of control listed in the federal income tax code. Most important (but not the only ones) are: the power to revoke the trust, the right to receive the trust’s income and/or principal, and the role of trustee. Grantor trust rules are actually quite complicated, and are sometimes subject to some interpretation — fortunately, the shades of meaning don’t show up very often. Most trusts are either quite obviously grantor trusts or quite clearly not.

Those are some of the most common terms you might see to describe trusts. In a future Elder Law Issues we will tackle some of the less common ones, like “Crummey” trusts and ILITs, QTIP and QDoT trusts, and — well, feel free to ask us to try to describe/define your favorite trust category.

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