Q: I have read that married couples may want to look into having a Bypass Trust. Can you explain what that is and the benefits?
A: A Bypass Trust, also referred to as a Credit Shelter Trust, is a type of trust designed to minimize or eliminate estate tax for married couples. The main purpose of a bypass trust is to take advantage of the estate tax exemption available to each individual. Bypass trusts are also beneficial for blended families and add protection from creditors. A portion of the estate assets are transferred into the trust upon the death of the first spouse, effectively "bypassing" the surviving spouse's estate.
The federal government and certain states, including New York, impose estate tax on the transfer of wealth at death if the total estate value exceeds a certain threshold. For 2023, the federal individual estate tax exemption is $12.92 million and New York's is currently $6.58 million. This means that if your estate does not exceed the exemption allowance, no estate tax is due at your death. In addition, there is an unlimited marital deduction for US spouses. So, even if your estate exceeds these exemption amounts, no estate tax is due if you were to leave everything to your spouse. By leaving all assets to a spouse, you are only deferring estate tax until the death of the second spouse. The assets left at the surviving spouse's death are subject to estate tax. So, by using the unlimited marital deduction, you are wasting the deceased spouse's estate tax exemption.
Upon the first spouse’s death, the bypass trust captures the New York State or federal estate tax exemption amount, (whichever is lower at the time). The rest of the estate goes to the spouse either outright or in a marital trust using the unlimited marital deduction. This preserves the deceased spouse's exemption in the credit shelter trust. The surviving spouse can be the trustee of the Bypass Trust and the beneficiary. Typically, the surviving spouse can draw income and principal from the Bypass Trust. Whatever is left in the bypass trust will be excluded from the surviving spouse’s estate for estate tax purposes.
Even if your estate does not come close to the historically high federal estate tax exemption, the exemption is set to sunset in 2026. At that time, it will be lowered to approximately $5.8 million. Further, in New York if your estate exceeds the New York exemption amount by 5%, there is no exemption at all, and the entire estate becomes taxable.
Bypass trusts are not used as much in states that do not impose estate tax since Congress passed into law the "portability election" in 2013. Portability allows a surviving spouse to use any unused portion of their deceased spouse's federal estate tax exemption by simply filling out IRS tax form 706. This eliminated the need for a bypass trust. However, New York State does not have portability, so the bypass trust remains an important estate planning tool.
In addition to reducing estate taxes, a Bypass Trust gives creditor protection to the surviving spouse. By naming an individual other than your spouse as trustee, you can protect your spouse’s inheritance from dissipation due to poor business decisions or a new spouse. Further, with a Bypass Trust you can set the remainder beneficiaries (i.e. those who inherit the trust property after your spouse’s death). This is appealing to second-marriage situations where each spouse has children from a prior marriage. Otherwise, there is a risk that the assets will be passed only to the surviving spouse's chosen beneficiaries, disinheriting your children.
By using a Bypass Trust, you can provide for your spouse after your death and ensure your descendants inherit with minimal or no estate tax. Consulting with an experienced trust and estates attorney is vital for couples with considerable assets or blended families.
Melissa Doris, Esq. is an attorney at Burner Law Group, P.C. focusing her practice areas on Estate Planning, Elder Law and Trusts and Estates. Burner Law Group P.C. serves clients from Manhattan to the east end of Long Island with offices located in East Setauket, Westhampton Beach, New York City and East Hampton.