By-Pass Trusts and the New Tax Law


As we all know by now, on December 17, 2010, President Obama signed the "Tax Relief, Unemployment Reauthorization, and Job Creation Act of 2010" (the "Act").  The Act makes major changes to the estate, gift and generation-skipping transfer tax laws for 2011 and 2012. 

In general, the Act increases the amount which an individual can leave at death or give away during life without having to pay an estate or gift tax to $5 milllion.  For married couples, the amount is $10 million ($5 million for each spouse).  This means that many estates that were subject to an estate tax would now be exempt, although the Act sunsets or reverts back to prior law in 2013 if Congress does not act.  If the Act is allowed to sunset without intervening action, the exemption amount would be $1 million as opposed to $5 million.

The Act also contains a portability provision which, in essence, allows a surviving spouse to use any unused exemption that his or her deceased spouse did not use.

Many married couples have traditionally used a "by-pass" trust as part of their estate planning.  A by-pass trust (also known as a "credit shelter" trust) allowed a couple to take advantage of both spouses exemption and preserve the estate tax exemption of the first spouse to die – essentially doubling the exemption for married couples. 

However, since portability allows the surviving spouse to piggy-back on the unused exemption of his or her deceased spouse – essentially also doubling the exemption - a question arises as to whether By-pass trusts are still needed.

The idea of abandoning the by-pass trust initially seems appealing.  This is because in a traditional family (and if it was not for the estate tax) most couples would be perfectly happy to leave everything outright to their spouse. However, there are a number of planning reasons why it still may be advisable to keep or create a trust for the benefit of the surviving spouse, including:

  • Portability May Sunset.  The estate tax provisions, including portability, are not permanent and are only for 2011 and 2012. They would need to be renewed for 2013 and beyond.
  • Estate Tax Exemption Could Sunset.  The $5 million exemption could go down to $1 million in 2013 if the Act sunsets.  Remember that 2012 is an election year. 
  • Portability Does Not Apply to GST Exemption.  If you wish to make a gift to grandchildren directly or in trust at the second death, preserving the GST exemption of the first spouse to die is an important option that is not available using portability.
  • Asset Protection.  Very often one of the planning benefits of a trust for the surviving spouse is that it provides some asset protection and management provisions that could be beneficial for the surviving spouse and ultimately the remainder beneficiaries.
  • Protects Against Second Marriages.  Putting property in trust protects the property if a surviving spouse remarries (when compared to an outright distribution to the spouse).
  • Asset Appreciation.  Putting assets in trust also removes the appreciation from the surviving spouses estate.  Protability does not provide this protection.

Like anything else, a person needs to look at their overall estate planning objectives.  A by-pass trust may or may not be appropriate for a person's specific situation, but it should not simply be dismissed as a planning option.