Congress's recent increase in the federal estate, gift, and generation-skipping transfer ("GST") tax exemption to $10 million per person adjusted annually for inflation ($11.18 million in 2018) is a welcome sweetener for many families, at least until 2026.
Absent any legislative change before then, the exemption will revert to $5 million per person plus the inflation adjustment.
Upon closer review, though, the higher exemption, like certain sugar substitutes, could be harmful. Married couples, particularly those in second marriages and blended families, should carefully review the funding formulas in any will or trust executed before 2018. Otherwise the death of one spouse could result in a "lopsided" subtrust structure that is contrary to the deceased spouse's intent, likely to sour relationships among survivors, and fraught with bitter income tax consequences.
Thus, the time is ripe for individuals and couples with taxable—or given the possible reversion—potentially taxable—estates to review existing trusts.
What Are Bypass Trusts?
Before this decade, married couples' estate planning documents often directed the estate tax exemption amount to pass to a "credit shelter," "family," "A-B," or "bypass" trust—usually for the benefit of a spouse and/or children—with the excess passing either to the surviving spouse outright or to a marital trust for the surviving spouse's benefit.
Accomplished by way of a formula in a will or revocable trust, the goals were to:
- Have the "bypass" portion fully utilize the deceased spouse's estate tax exemption and (along with subsequent appreciation in value) fall outside the surviving spouse's taxable estate, and
- Have the "marital" portion pass upon the first spouse's death estate tax free to the surviving spouse on account of the estate tax marital deduction.
An estate plan then also may have provided that the "bypass trust" be further divided into a "GST exempt" trust (funded with the GST tax exemption amount remaining at death) and a "GST non-exempt" trust (funded with the estate tax exemption amount exceeding the GST exemption amount that funded the GST-exempt trust), with the excess flowing to or for the benefit of the surviving spouse.
Bypass trusts are funded after consideration of assets passing outside the will or trust at death (e.g., survivorship accounts, qualified plans, IRAs), lifetime taxable gifts, and estate administration expenses. Bypass trusts not only keep a deceased spouse's assets (and appreciation thereon) out of the surviving spouse's gross estate for estate tax purposes, but they also have creditor protection benefits and facilitate GST tax planning. At the same time, bypass trust assets do not receive a "step-up" in income tax basis upon the surviving spouse's death.
Even though portability of a deceased spouse's unused estate tax exemption became law in 2011, bypass trusts remain important today for GST tax planning purposes. Specifically, a deceased spouse's unused GST tax exemption is not portable to the surviving spouse. This is one reason why after Congress enacted portability, higher wealth married couples often continued to engage in bypass trust planning. Will and revocable trust formulas that fund bypass trusts (GST-exempt or otherwise) should be carefully reviewed in light of current law.
The Need to Review Pre-2018 Bypass Trust Formulas
If a married couple fails to update a "bypass trust" estate plan executed before 2018, and if one spouse dies in 2018, then all or most of the deceased spouse's assets could end up funding the bypass trust(s) without any excess flowing outright to, or in trust for, the surviving spouse (as was intended upon execution of the will or trust). Thus, if one spouse dies in 2018, then his or her outdated estate plan drafted in a prior year when the year-of-death estate tax exemption amount that would fund the bypass trust was significantly lower (e.g., $675,000 (2000), $1,000,000 (2003), $3,500,000 (2009), or $5,340,000 (2014)), would end up sheltering up to $11,180,000 (2018) in a bypass trust. The assets of such trust would not receive a step-up in income tax basis upon the surviving spouse's death. Accordingly, what was a reasonably balanced and intentional estate plan under prior law would become "lopsided" upon a spouse's death today. If a married couple's combined estate is less than $22.36 million, then estate planning under current law requires careful consideration of which assets will and will not receive the step-up in income tax basis upon a spouse's death.
An overfunded bypass trust could be especially harmful in a second marriage or blended family situation. Depending upon asset titling and beneficiary designations, a bypass trust for the benefit of a spouse and/or children of a first marriage could be overfunded upon one spouse's death. Overfunding could effectively thwart a deceased spouse's intent carefully reflected in estate planning documents that were drafted under prior law when there was a significantly lower estate tax exemption.
A harmful result of overfunding would stem from the failure of the surviving spouse to receive assets outright or in a marital trust. If an overfunded bypass trust fully or partially disinherits a surviving spouse, then the spouse can assert a claim under North Carolina's spousal elective share law. The elective share law requires a deceased spouse to leave a statutorily-defined minimum percentage of assets to the surviving spouse, regardless of what the estate planning documents say.
While a spouse can waive the right to claim the elective share in a valid, written premarital or post-marital agreement, the spouse could insist on receiving outright his or her elective share. If the spouse is successful in doing so, the spouse then could name beneficiaries who are not necessarily the bypass trust beneficiaries designated by the deceased spouse. An overfunded trust could alter the deceased spouse's intent and, as a result, harm family relationships that already may be strained on account of the second marriage or blended family circumstances.
What About Existing Bypass Trusts Benefitting a Surviving Spouse or Designed as GST-Exempt Trusts?
As part of an estate planning document review necessitated by the higher transfer tax exemptions under current law, bypass trust trustees also should evaluate the creditor protection benefits of keeping assets in trust, specifically protection from divorcing children-in-law, a surviving spouse's future remarriage, or judgment creditors. Trustees also should review the trust document's distribution standards, powers of appointment, and rights of withdrawal in the context of current law and family circumstances.
Moreover, to obtain a step-up in the income tax basis of bypass trust assets that otherwise would not receive one upon a surviving spouse's death, bypass trust trustees may want to explore permissible distributions of "low-basis" assets to a surviving spouse or other beneficiaries, or even a court-ordered trust modification to accomplish the step-up in basis through modernized trust terms.
Congress's generous but temporary $10 million, inflation-adjustable per person transfer tax exemption is a positive development for many families with taxable or potentially taxable estates. However, upon the death of a spouse with an outdated bypass trust plan, the higher exemption amount could frustrate a decedent's intent and tax objectives.
Accordingly, married couples, especially those in second marriages and blended families, should heed this warning about overfunded trusts and invest time in a comprehensive review of their estate planning documents. Family relationships and tax savings undoubtedly will be sweeter as a result.
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This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.