Traditionally, due to lower estate tax exemption amounts, many married couples would use bypass trusts or credit shelter trusts as part of a typical estate plan. For example, on the death of the first spouse, assets in that spouse’s revocable trust would be allocated to a bypass trust (frequently referred to in the trust document as a family trust) up to the amount of the deceased spouse’s remaining estate tax exemption, with the balance allocated to a marital trust for the surviving spouse. The bypass trust would not only pass estate tax free at the first spouse’s death, but would also be outside of (i.e., bypass) the surviving spouse’s taxable estate at death. In addition, the bypass trust assets might continue from generation to generation without being subject to any additional “transfer taxes” like the generation-skipping transfer (GST) tax, if GST exemption was allocated to the trust. This type of planning continues to provide a variety of benefits.
With the passage of the 2017 Tax Act, the estate tax exemption amount has increased from $5,490,000 per individual in 2017 to $11,180,000 per individual in 2018, or $22,360,000 per married couple. This generally means that an estate tax will not be levied unless assets are in excess of these amounts. As a result, many couples are finding that their total assets are well below the current estate tax threshold. However, it is important to keep in mind that this increase in exemption is temporary due to a sunset in the Tax Act. Beginning Jan. 1, 2026, the exemption will fall back down to $5 million adjusted for inflation.
While bypass trusts are great for sheltering assets from the estate tax, one income tax drawback is that the assets in a bypass trust generally do not receive a “basis step-up” at the death of the surviving spouse.
You may recall that when someone dies holding assets, those assets receive a basis adjustment to fair market value at the time of death. For example, assume that D purchased 1,000 shares of AAPL stock in 2002 for $1,120 at $1.12 a share. These shares are now worth about $200,000, at $200 per share. If D wanted to sell the shares now, the taxable gain would be $198,880 ($200,000 minus the $1,120 cost basis) resulting in a tax of approximately $59,266 (assuming a 20 percent long-term capital gains tax, 3.8 percent net investment income tax and 6 percent state tax). However, D instead designates C as beneficiary of the AAPL stock upon D’s death. D dies and C immediately sells the AAPL stock. How much is C’s tax liability? The answer is zero because instead of having a cost basis of $1,120 or $1.12 per share, the basis was “stepped up” to $200,000 or $200 per share as a result of D’s death.
How does this apply to bypass trusts? Upon the death of the first spouse, the assets going into the trust receive a stepped-up basis. However, the surviving spouse may live for a long time after the first spouse’s death, and the assets held in the bypass trust could significantly appreciate in value. Consider that upon the surviving spouse’s death, the combined value of the surviving spouse’s assets, as well as those assets in the bypass trust, could be less than the estate tax exemption while at the same time being highly appreciated. When the second spouse dies, the assets in the bypass trust will not receive a basis step-up, and, should those assets need to be sold, the next generation of beneficiaries may incur significant income tax liability. Consequently, it may be beneficial to pull the assets in the bypass trust into the surviving spouse’s estate (triggering a basis step-up) to provide the next generation of beneficiaries a significant income tax savings without triggering an estate tax.
For existing bypass or family trusts, there are a variety of methods to pull assets into a surviving spouse’s estate to allow a basis step-up, if appropriate, oftentimes allowing the trust assets to continue in trust without otherwise impacting the distribution scheme or other trust benefits. However, there are a variety of considerations requiring careful analysis, and it may not be appropriate in every circumstance.
If you currently have a bypass trust/marital trust arrangement, there are provisions that may be included in your documents that will make such income tax planning nearly seamless. In fact, more recent plans quite possibly could already have such provisions. However, if your estate planning documents were created a few years ago, you may want to revisit them to make sure that your surviving spouse and other beneficiaries will be afforded the opportunity for income tax savings.
Similar methods may also be used for other types of irrevocable trusts that otherwise would not be included in a beneficiary’s estate allowing those assets in the trust to receive a basis step-up upon the beneficiary’s death, potentially providing significant income tax savings to the successor beneficiaries. There are also strategies that may be available to implement if the creator of the irrevocable trust, the “grantor,” is still alive to achieve a basis step-up at the grantor’s death.