Do I Need a Bypass Trust?

Portability was enacted in 2011. Before 2011, if a person died with unused lifetime exclusion, this excess exclusion was permanently lost. After 2010, the surviving spouse could elect to take that excess lifetime exclusion amount and add it to their exemption amount and have that available in their estate.

By creating the ability to “port” the unused exclusion to the surviving spouse, the law seemed to eliminate the requirement to try to equalize assets between spouses in separate property states.

Here is an example:

Frank died in 2022 worth $5 million and gave all of his assets to his wife Mariam. She is worth $12 million before she gets assets from Frank’s estate. Mariam dies in 2023 worth $17 million. Since Frank gave all of his assets to Mariam, he has a zero taxable estate and his unused lifetime exemption is $12 million (actually $12.060 but I am rounding). If the executor of the estate does not make the portability election, then Mariam’s heirs will owe about $2 million of federal estate tax. By making the portability election, no federal estate tax is owed since Mariam now has a lifetime exemption of $24 million and her estate is only $17 million.

Many farmers now assume that they may not need a bypass trust since all of the unused exemption can be transferred to the surviving spouse. The biggest benefit of portability is the step-up of assets when the surviving spouses passes. However, if there is a taxable estate for that spouse, the step-up may have little or no value if a 40% or higher estate tax is due immediately.

There may be several reasons why having a bypass trust for your estate makes more sense than portability.

First, there is no inflation adjustment on the exclusion that is transferred to the surviving spouse. If the assets are placed into a bypass trust, the spouse will get income for life and the ability to reach in for principal if needed, however, when the spouse passes away, all of the assets in the bypass trust are not included in their estate even if the assets have doubled or tripled in money.

Second, many surviving spouses will get remarried and if all of the assets go to the surviving spouse, there can be an issue with the deceased spouse wishes for children inheriting their assets not being fulfilled since the assets are now with the spouse. The bypass trust spells out how these assets will be distributed upon the death of the surviving spouse. This, in many cases, is more important than any estate or income tax savings.

Third, asset protection for the surviving spouse can be achieved with the bypass trust versus an outright gift to the spouse. The trust can be used to “protect” the spouse from creditors or others that may not have the best intentions for that spouse.

These are some of the key reasons why you might want to use a bypass trust instead of counting on portability. As with any estate planning situation, you really do need to discuss this with your estate tax advisor to see what is best for you.