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For a traditional married couple, the estate planning has become simpler in many ways.聽聽Before the estate tax was increased on both the State and Federal level, we were fixated on saving estate taxes.聽聽Using simple techniques like bypass and marital trusts and insurance trusts called ILIT鈥檚, were the gold standard in estate planning.聽聽Today many of those types of plans are irrelevant and maybe even harmful in an estate plan.
What Is a Bypass Trust?
Bypass trusts are trust created in the estate of the first spouse to pass away.
To illustrate, if a husband died when the exemption was $1.0, his Will left $1.0 million in his bypass trust to protect his exemption (the amount he could pass to a non-spouse tax-free) and then the balance would be distributed to his surviving spouse tax free. The idea was that when the second spouse died, she would have her own exemption and the monies in the bypass trust would pass tax free to the next generation.聽聽If the exemption was $1.0 (or more) when the survivor died, then both the bypass trust amount and the exemption amount when the 2nd聽spouse died would escape estate taxation.
This is the most common type of estate plan that was utilized in the last 25 years and many clients still have these documents in place. In instances where the first spouse has died, there still exists a bypass trusts for the benefit of the surviving spouse.聽聽For those couples with these types of estate plan but with assets under $6 million, it鈥檚 not too late to change them.聽聽But, what if one spouse has died and the surviving spouse is still alive with assets in a bypass trust.聽聽Is there more planning to be done?
An Example of Bypass Trusts in New York State
Assume a couple in 2000 with $1.8 million worth of assets.聽聽Husband died and $1.0 million was payable to the bypass trust under his will for the benefit of his wife.聽聽According to the terms of the trust: (1) she can have all the income, (2) she is entitled to distributions for her health, education and support and (3) a trustee can distribution all the trust assets to her for any purpose, even if the trust is depleted.聽聽The purpose of this trust was clearly to shield the first million of the estate from estate taxes when the surviving spouse later died but gave the trustee the power to make unlimited distributions to the spouse.聽聽Now also assume the wife has, in the intervening years, protected her own $800,000 from the cost of long-term care by placing those assets into an聽Irrevocable Trust.聽聽In the meantime, the bypass trust has grown to $1.6 million dollars.聽聽There are two glaring problems: Capital gains tax and cost of long-term care.
When the surviving spouse dies, the assets in her irrevocable trust will be counted as part of her taxable estate.聽聽If she dies this year, she will have a NY State estate tax exemption of $5.93 million (2021) and her federal exemption is $11.7 million.聽聽Clearly, she does not have a taxable estate.聽聽Her assets will pass tax free to the next generation.聽聽However, the assets in the bypass trust will have a capital gains tax for any growth in principal.聽聽Assuming the capital gain of $600,000 and a capital gain rate of 33%, there could be a capital gains tax of just under $200,000.聽聽If the bypass trust assets were not in the trust, but in the surviving spouse鈥檚 estate, there would be no estate tax and no capital gains tax.聽聽In this case, assuming no other facts, it would may be best to distribute the assets to the surviving spouse and allow the assets to obtain a 鈥渟tep-up in basis at her death.
The second problem with the bypass trust is that the broad distribution rights under the trust makes those trust assets available to pay for the spouse鈥檚 long-term care.聽聽She has protected her own assets, but likely the $1.6 million is available to be spent down.聽聽In this case, if the trustee were to distribute the trust assets to the surviving spouse, she could add those assets to her Irrevocable Grantor trust.聽聽She would enjoy the income in the trust, her estate (i.e. her heirs) would get a step-up in basis on her death and the assets could be shielded for the cost of nursing home care or catastrophic illness after five years.
This same scenario applies in the case of insurance trusts that were created during the life of the first spouse to die.聽聽The trust was likely intended to shield the surviving spouse鈥檚 estate from estate taxes, but the increased exemptions make the insurance trust unnecessary.聽聽There is an income tax return due each year which is a burden in both time and money.聽聽There is no step-up in basis at the death of the surviving spouse and the assets are probably not protected from the cost of long-term care.
An Estate Planning Attorney Can Help Restructure Trusts
While the trusts in this example give the trustee wide latitude in distributing trust assets to spouses, not all trusts are the same.聽聽If the trustee does not have the power to distribute outright to the spouse, there may be an alternative way to accomplish these objectives.聽聽New York state has a very generous聽decanting statute聽that may be utilized to 鈥渇ix鈥� the trust.聽聽It may not be too late.
Learn more about聽estate planning here.
