Understanding Bypass Trusts (also known as a B Trust or Credit Shelter Trust)

A bypass trust is a vehicle, often used alongside a marital trust, to minimize federal estate tax on the combined estates of a married couple. Assets are transferred from the estate of the first spouse to die. They go into the bypass trust so the federal applicable exclusion amount is fully used (the maximum amount that can be sheltered from gift and estate tax by the unified credit). The rest of the assets of the spouse that has passed will be transferred into a marital trust, typically set up as a qualified terminable interest property (QTIP) trust. While the marital trust isn’t essential to minimize estate taxes, married couples may want to use such a QTIP if they have children and are concerned about a second marriage.

The surviving spouse is only given certain rights and limited control over the assets in the bypass trust. They may receive income from the trust or may be given the right to invade the trust principal for his or her health, education or other approved support or maintenance. They may also get a limited power of appointment over the assets in the bypass trust. This permits the power holder to direct that the assets in the trust pass to a limited class of beneficiaries (not himself or herself, his or her estate, creditors or the creditors of his or her estate).

With the marital trust, the surviving spouse must receive all income for life from the trust, but the creator of the trust can decide where the assets pass when the surviving spouse dies. The assets will be included in the estate of the surviving spouse, who can use their applicable exclusion amount to shelter some or all of the assets from estate tax. The assets transferred to the marital trust will not be taxed at the death of the first spouse. The estate tax will be postponed until the second spouse dies.

Bypass and marital trusts are typically used by a married couple with assets in excess of the applicable exclusion amount, as when used in conjunction with a marital trust, a couple could conceivably protect up to $10,900,000 (in 2016) from estate taxes.

To maximize the effectiveness of this strategy and ensure the full use of the applicable exclusion amount, before setting up the bypass and marital trusts, the assets of each spouse should be equalized with each spouse owning in their own name an equal share of the total assets.

When does a Bypass Trust make sense?

This approach should only be considered if a married couple expects to have assets in excess of the applicable exclusion amount at the death of the first spouse. Those with assets below the applicable exclusion amount will typically have joint wills or they may own all assets jointly with right of survivorship. In that situation, the surviving spouse will receive the assets tax free due to application of the unlimited marital deduction. The surviving spouse’s estate will not incur estate taxes if the assets are below the applicable exclusion amount upon their death.

Strengths of this approach

Use of both bypass and marital trusts allows the surviving spouse to have full benefit of wealth while minimizing estate taxes. It’s an especially effective estate planning strategy when the married couple would like some or all of their assets to pass to their children or others. Although the surviving spouse must receive all income from a QTIP marital trust, the creator of the trust can designate who the assets in the trust pass to when the surviving spouse dies. This prevents your assets from ending up in the hands of the new spouse or his or her relatives if your spouse remarries. The use of the bypass and the marital trusts can also minimize the federal estate tax incurred in each spouse’s estate by allowing each spouse to fully use his or her applicable exclusion amount.

Additional benefits include the professional management of assets for the surviving spouse and beneficiaries, the ability to avoid probate and the ability to maximize use of each spouse’s exemption from the generation-skipping transfer tax exemption.

What are the trade-offs to this approach?

There are some costs involved with this level of estate planning as you’ll need an attorney to advise you on the estate and tax implications of setting up a bypass trust and to draft the trust and assist with retitling of assets as needed.  You’ll also need to appoint a trustee for the bypass trust, and if it’s sizable, you may want to hire a professional trustee who will have to be compensated for his or her services. Typically, he or she receives a percentage (usually 1 percent or more) of the assets under management.

How to do it

The following steps will need to be taken to deploy this strategy:

  • Hire an estate planning attorney to draft the bypass trust
  • Choose an individual or institution to be the trustee of the bypass trust
  • Choose beneficiaries and remainder persons for the bypass trust

Give us a call today to discuss if this approach makes sense for you and your family.

Caution: This may not be the proper strategy for some married couples due to a tax law passed in 2001 that replaced the state death credit with a deduction starting in 2005. See your financial professional for more information.

LPL Financial Representatives offer access to Trust Services through The Private Trust Company N.A., an affiliate of LPL Financial.

Hauser Group Wealth Management and LPL do not provide legal advice or services. Please consult your legal advisor regarding your specific situation.