In estate planning, a trust known as a Bypass Trust is used together with a marital trust in order to pass the maximum amount of money to beneficiaries without having to pay estate tax. In this type of tax planning structure, both spouses are able to use their unified credit to offset estate taxes due.
Bypass Trust Planning
Basically, the way it works is the marital deduction trust receives all assets left directly to the surviving spouse or for their exclusive benefit. The exempt amount then goes into the bypass trust. The main objective of a bypass trust is to prevent the assets in the trust from being included in the estate of the surviving spouse. It is important to understand that the marital deduction is not available for the assets transferred to the bypass trust.
Next the executor will use the unified credit of the decedent to offset any estate tax, which is why the bypass trust is usually funded with assets up to the applicable exclusion amount. The amount of assets in the tax saving bypass trust, bypass the surviving spouse’s taxable estate. The amount of assets transferred to the bypass trust is part of the decedent’s estate, but the unified credit is applied resulting in a zero estate tax liability.
Bypass Trust Rules
In order for a bypass trust to take advantage of all the potential tax savings, it must meet certain rules laid out by the IRS. These rules include:
1. Access to the trust by the surviving spouse must be limited during their lifetime – Basically, a surviving spouse cannot be given unrestricted right to withdraw the principal. However, a grantor can still give a surviving spouse the right to withdraw income and principal from the trust for specific reasons such as health, maintenance, education, and support.
2. Power to distribute trust assets upon death of the surviving spouse must be limited – Basically, the surviving spouse cannot possess the right to give the trust assets to themselves, their estate, or creditors.
A bypass trust can provide a good amount of flexibility if they are planned and drafted correctly. It is important to understand that the IRS is very picky when it comes to the wording of a bypass trust and it would be wise to seek professional help when trying to draft one.