As with any great relationship, give and take is an important component. If we give too much without taking anything, we will tire and grow frustrated quickly. If we take too much and give little or nothing, our better half will likely be discouraged. The same goes with estate taxes at death. If we leave too much money to a spouse when we die, estate taxes may be owed at their death. If we do not leave them enough money, we may jeopardize their standard of living. Bypass trusts, when used appropriately, allow married couples to provide for one another after the death of the first spouse while minimizing estate taxes at the death of the second spouse.
Suppose Harry and Sally are married with two children.
They want to provide for each other, but they also want to minimize their estate taxes so they can pass as much money on to each of their children as possible after death. If Harry dies first and leaves all of his money to Sally, there would be no estate taxes owed at his death because married couples are allowed to pass an unlimited amount of money to each other in life or at death without any tax ramifications. However, at Sally’s death, her estate may owe taxes on any amount over the allowable estate tax exemption, leaving less money for their children. On the other hand, if Harry doesn’t leave enough money to Sally when he dies, two things may happen. First, Sally may not have access to enough money to continue living in a way she is accustomed to. Secondly, his estate may owe taxes when he dies. The bypass trust allows couples to use the unlimited marital gifting along with their estate tax exemption amount to the fullest potential.
To use the Bypass Trust to the fullest extent, the trust would be funded at Harry’s death with an amount of money or assets equal to his estate tax exemption. His remaining assets over the exemption amount could then pass to Sally outright for her benefit. By doing this, Sally can benefit from the income produced by the assets in the bypass trust for the remainder of her life, and she will also have access to the assets left outright to her by Harry. The assets in the bypass trust will not be included as part of Sally’s estate when she dies, even though she can receive the income from it during her life since Harry used his estate tax exemption amount to fund the trust. The assets she received from Harry outright will be included in her estate, but she will also have an estate tax exemption amount to apply to those assets at her death. After Sally’s death, the assets in the Bypass Trust will pass to their children. If the assets stay in trust for the children, they will have the added benefit of creditor protection and protection from lawsuits since the assets will be held in trust.
If structured properly, a Bypass trust can help couples accomplish a number of estate planning goals. Most importantly, this type of planning allows married couples to provide for each other after the death of the first spouse and further allows assets to pass on to children or grandchildren at the death of the second spouse in the most tax-efficient manner possible. In situations where children from previous marriages are involved, Bypass Trusts are often used alongside QTIP Marital Trusts to provide a seamless estate planning strategy.