This is a part in a series of articles I have written on various types of irrevocable trusts.
Understanding Bypass Trusts
Prior to 2012, many married couples created joint trusts known as “A-B” trusts. The problem now is that these trusts may actually cause more harm than good.
In this article, I discuss Bypass Trusts. Who needs them. Who does not. And what to do if you have one and don’t want it. We also will talk briefly about QTIP trusts and Clayton Elections.
The A-B Trust
An A-B trust means that when one spouse dies first, the trust will split into two subtrusts. It splits into the A trust and the B trust. The A trust is known as the Survivor’s Trust or Marital Trust. The B trust is known by many names. These include the Bypass Trust, Decedent’s Trust, Exemption Trust, Credit Shelter Trust, and/or the Non-Marital Trust.
Often, a formula will dictate how much of the assets must go into the A trust, and how much must go into the B trust after the first death. These formulas are known as “marital funding formulas.” They depend on whether there is a federal estate tax and the reason for creating the B trust.
Many times, the assets that go into the A trust are controlled by the surviving spouse (as trustee), who will retain total control over how to use these funds. The surviving spouse also has the right to change the A trust at any point as well the future beneficiaries of the A trust. This is because the A trust is often funded with the surviving spouse’s one-half share of assets.
The B trust, on the other hand, is often funded with the decedent’s one-half share. Sometimes, the trustee of the B trust may be the surviving spouse. Other times, the trustee may be someone else, other than the surviving spouse. The B trust may or may not benefit the surviving spouse during her lifetime. All B trusts have one thing in common. The surviving spouse cannot change the beneficiaries of the B trust after the first spouse has died. This means that when the first spouse dies, the B trust is irrevocable.
Why split the trust into two trusts?
There are two main situations where people need(ed) to create A-B trusts.
1. A Bypass Trust Can Protect Blended Families
Do you remember the Brady Bunch? Mike and Carol Brady are married and each brought three children from a prior marriage. Mike’s sons are Greg, Peter, and Bobby. Carol’s daughters are Marcia, Jan, and Cindy.
Let’s imagine Mike and Carol did a joint trust leaving everything to one another. Furthermore, the trust says upon the passing of the second spouse, all the assets will be divided equally among all six children. Sounds good, right?
Now, let’s say Mike dies first and leaves all the assets to Carol in the trust. Carol has the right to do whatever she wants with the assets and the trust. This broad power gives her the right to amend the trust after Mike has died. Carol decides that Mike’s three boys are going to be taken care of just fine. After all their biological mother is rich, and she will leave assets to them when she dies. So Carol amends the trust and states that after she dies, only her three daughters will inherit the assets. Mike would not be happy, and the three boys may stand to get nothing!
Had Mike and Carol created a bypass trust, this is what could have happened:
- While both Mike and Carol are alive, they can use the assets freely for their needs. The trust is revocable while they both are alive.
- When Mike passes first, the trust splits into two — the A trust and B trust. Mike’s 50% share funds the bypass trust (B Trust). This is irrevocable once Mike dies. The B trust can make income and/or principal available to Carol for her needs, if necessary. Carol meanwhile has access to her 50% share (A trust), which she can manage as she pleases. If the A trust is not enough to sustain Carol, she can take from the B trust for her health, education, maintenance, and support. The trustee of the B trust may be Carol but it can also be someone else.
- When Carol passes away, the B trust gets paid out to Mike’s children. Carol cannot change this. The A trust gets paid out to whoever the trust states at the time Carol dies. This means Carol had the right to have everything in the A trust go to her children. The net results is that each child took an equal share from the respective two trusts.
We can replace Carol with Mike in the above example just as easily, and the result would be similar.
Thus, the B trust protects the children of the deceased spouse from a surviving spouse who decides to later rewrite or amend the trust. Furthermore, it protects the surviving spouse as well. For example, let’s say Carol dies first, and Mike remarries and then gets divorced later. The bypass trust is off-limits to Mike’s divorcing spouse.
2. A Bypass Trust Can Protect from Estate Taxes
The second reason people created A-B trusts was to protect the assets from the estate tax. Prior to 2012, each spouse held a lifetime exemption that was “use-it or lose-it”. For example, Harold and Wilma are married and own $5 million of assets. H dies in 2005, leaving everything in trust to W. In 2009, W dies, leaving everything to the children. When W dies in 2009, she could only pass $3.5 million tax-free. This would mean that a $675,000 tax would be due nine months after W died. If the main asset was the home, the home would likely need to be sold or refinanced quickly after W’s passing in order to timely pay the tax.
Enter A-B trust to the rescue. If H and W created an A-B trust and then H died in 2005, here’s what would have happened:
- H’s exemption in 2005 was $1.5 million. This amount would be placed in the bypass (B) trust and would be able to grow estate-tax free. The balance, $3.5 million would be available to W (with $2.5 million in the Survivor’s Trust (A trust) and $1 million in the Marital Trust (C trust)).
- When W dies in 2009, the exemption is $3.5 million. Assuming she left $3.5 million to her children at death, all of this would pass tax-free. The amount in the B trust would also pass to the children estate tax-free.
Therefore, a popular use of the bypass trust prior to 2012 was to shelter the deceased spouse’s estate tax exemption. Because, if you didn’t, all the assets would go to the surviving spouse, who would only have one exemption to use at death. The deceased spouse’s exemption would be wasted.
That all changed, though, in 2012.
Why B Trusts Started to Become Unpopular
In 2012, Congress permitted portability of both spouse’s exemptions. This meant that if one spouse passed away and did not create a B trust, the surviving spouse could still elect to use the “deceased spouse’s unused exemption” (DSUE). Moreover, under the Tax Cuts and Jobs Act (TCJA), the federal estate tax exemptions became much higher in 2020 than they ever were prior to 2012. These two facts combined meant one thing. Most people didn’t need a B trust anymore simply to save on estate taxes.
For example, H and W are married and have a $5 million taxable estate. H dies in 2019, leaving everything in trust to W. When H dies, W can file for H’s DSUE, which was valued at $11.4 million. When W dies in 2020, she can leave $11.58 million tax-free to her heirs, plus H’s $11.4 million exemption. Because H and W have a taxable estate far less than $23 million, there is no need for a B trust.
In fact, if H died with a B trust still in place, it actually would have backfired! For example, using the above example, let’s say H and W created an A-B trust in 2005 for their $5 million estate. If H died in 2020, the A-B trust requires that the B trust must be created and funded with H’s share, up to the maximum amount of estate tax exemption permitted under law ($11.58 million in 2020). Thus, in this case, $2.5 million (H’s share) would need to be funded into the B trust. The remaining $2.5 million would fund the A trust. So what’s so bad about that result?
The Shortcomings of Bypass Trusts
As beneficial as bypass trusts may be for certain reasons, they do come with certain strings attached.
1. Assets in a Bypass trust are not includable in the surviving spouse’s gross estate.
In other words, such assets do not get the step-up in basis on the death of the surviving spouse. Instead, assets will be stepped-up to fair market value only on the death of the first spouse. Thus, any appreciation on the assets from the death of the first spouse to the death of the second will be taxed to the children upon the surviving spouse’s demise. This is an important consideration to keep in mind for those who will inherit assets through a Bypass trust. In the case of blended families, it makes sense to live with this tradeoff because the beneficiaries are at least guaranteed to receive some assets. In other cases, this loss of step-up in basis may have a disastrous result for the beneficiaries.
2. There are trust administration costs and fees that are associated with having a Bypass trust.
For instance, this includes the cost to allocate assets to the Bypass Trust when the first spouse dies. This includes appraisals, accounting fees, and attorney’s fees, as well as any ongoing administration costs of administering the Bypass Trust.
Third, as already noted, the Bypass Trust cannot be changed by the surviving spouse. If certain life events require that the decedent’s children should no longer be the beneficiaries of the Bypass trust, this cannot be changed.
Finally, a principal residence in a Bypass Trust does not qualify for the IRC §121 exemption. This means that if the surviving spouse wants to sell the primary residence, and if the primary residence is owned by the Bypass trust, the $250,000 capital gains exemption under IRC §121 would not be available to the surviving spouse.
Therefore, each family’s situation is very different. It’s important to weigh all the considerations before taking any decisions one way or the other. We highly recommend speaking to an advisor.
Can I Get Rid of my Bypass Trust?
If both spouses are still alive, removing a bypass trust is easy to do. This is because the joint trust is likely revocable. Either an amendment or a restatement of trust is in order. Through proper planning, a married couple can “get rid” of their bypass trust.
However, once one spouse passes away first, things become much more difficult because the creation of the bypass trust becomes mandatory. Furthermore, the bypass trust becomes irrevocable.
There are a few solutions to this problem.
Option 1: Petition the Court
Under California Probate Code §15403, if all beneficiaries agree, a trustee or beneficiary of an irrevocable trust may compel modification or termination of the trust upon petition to the court. This is generally a time-consuming and costly affair but straightforward. Potential issues can arise though if there are minor or unborn beneficiaries, or beneficiaries who may be disadvantaged if the Bypass Trust is not funded.
Even if the beneficiaries do not agree, a trustee can still go to court under California Probate Code §15409. The reason cited would be a change of circumstances that was not anticipated by the creator of the trust. For example, if the bypass trust does not even contain enough assets such that the maintenance and cost associated with funding makes little financial sense. The trust can then be terminated by court order.
Option 2: Private Party Agreement
Pursuant to Probate Code §15404, the parties can bypass court (pun intended!) and agree amongst themselves that the trustee will not have to fund the bypass trust.
There are several challenges with this approach though.
First, both settlors (trust creators) must still be alive in order to safely qualify under this Probate Code section. Some practitioners read this statute to mean only one settlor (the surviving spouse) is sufficient. This is incorrect and very risky for the reason stated next.
Second, even under this agreement, the fiduciary (trustee) will remain exposed to future claims by not obtaining a court order. For example, say a beneficiary agrees that a bypass trust is not necessary. Later the surviving spouse omits that beneficiary and his children from the trust. As a result, the beneficiary’s child is permitted to sue the trustee later down the line for not having gone into court to modify the trust under §15403.
Option 3: Keep the Bypass Trust
In situations like blended families, it may make sense to keep the bypass trust regardless of whether there are estate taxes due. The bypass trust still guarantees that the children will inherit the principal from the bypass trust after the death of the surviving spouse.
Another example includes taxable estates. Some estates may be near or above the estate tax threshold. In this case, a bypass trust may still make sense to keep.
Option 4: Clayton Election
Suppose the terms of the bypass trust contain special language that permits assets to instead be funded into a marital trust. In this instance, a QTIP election can be made on Form 706 and the assets would get a step-up in basis on the second death. This is known as a Clayton Election.
Under a so-called Clayton election, at the first death, the surviving spouse or an independent representative of the decedent can select certain assets for QTIP election. This means that the surviving spouse has total flexibility after the first death to determine what to do. Is it better to keep the bypass trust for certain assets, while other assets benefit from future step-up in basis? If so, the assets selected will get the step-up and become part of the surviving spouse’s estate. Any other assets not selected will automatically be funded into the bypass trust.
Should I Include a Bypass Trust in My Trust?
Like any good lawyer would say, it depends!
If you don’t have a taxable estate, don’t have a blended family, won’t have asset protection issues likely in the future, and have an otherwise modest estate, you may benefit from a disclaimer trust. This is a somewhat flexible option. At the death of the first spouse, the surviving spouse is permitted the option to disclaim assets. This means, the assets would then fund the bypass trust. This optional A/B split offers the trustee some time: nine months from the date of death. During this period, they may determine if the bigger problem at the second death is the estate or capital gains tax. It’s important to work with an attorney for making a qualified disclaimer under IRC §2518.
For larger estates, a Clayton election can provide even more flexibility. If an A/B split is required, the surviving spouse can choose the tax treatment of the B Trust. They may choose to keep it as a traditional B Trust. This option provides estate tax protection but often results in higher capital gains tax. Or they may treat it as a “QTIP Trust”. This option does not provide estate tax protection, but is more favorable with respect to the capital gains tax. Or, the best of both worlds: putting some assets in the QTIP, with others remaining in the Bypass.