Bypass the Bypass Trust?

Implications of the 2010 Tax Act’s “portable” exclusion. Prior to 2011, the bypass trust, also known as the credit shelter trust, family trust, and the “B” trust, was necessary to ensure that the applicable exclusion amount of the first spouse to die wasn’t wasted.  If all of the deceased spouse’s assets were transferred to the surviving spouse that qualified for the marital estate tax deduction, the assets would be included in the surviving spouse’s estate upon his or her death.

However, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Act) has replaced the old concept of “use it or lose it” with the “portability” concept. Under this 2010 Tax Act, a surviving spouse can utilize the unused applicable exclusion of the deceased spouse.

Portability Provisions

The 2010 Tax Act redefines the term “applicable exclusion amount” to equal the sum of

  1. The “basic exclusion amount” ($5 million); and
  2. In the case of the surviving spouse, the deceased spousal unused exclusion amount (DSEUA)
  3. DSEUA equals the unused basic exclusion amount of the “last” deceased spouse of the surviving spouse. Note that it is irrelevant whether the deceased spouse actually had assets equal to his unused exclusion amount.
  4. Accumulation of unused exclusions are not allowed.The portability rule does not apply to the possibility of accumulating the unused exclusions from several marriages. In the case of gifts, however, a person possibly could use the DSUEA from multiple spouses.  But the maximum amount of the exclusion amount for a person will never be more than twice the basic exclusion amount.
  5. If the amount of DSUEA is later reduced (due to another marriage and death) where the surviving spouse used or intended to use a larger amount of DSUEA
  6. In the case of a  lifetime gift, there should be no additional gift tax due because the credit against the gift tax was properly allowable at the time of the gift. However, the timing of a remarriage could trigger a gift tax. If the DSUEA of a donor decreases after a gift has been made, but before the end of the calendar year in which the gift has been made, the donor could owe gift tax.
  7. Recapturing of the gift tax
  8. The reunification of the gift and estate tax appears for the possibility of lifetime gifts that weren’t subject to gift tax to becoming subject to estate tax. As a result, the gift tax would be “recaptured” at death.

2 Rules to the Portability Provisions

  1. The executor must make an election on the estate tax return for the surviving spouse to be able to use the DSUEA and compute the amount of the DSUEA.  The definition of the DSUEA references the basic exclusion amount of the “last such deceased spouse”, not the basic exclusion amount of the last such deceased spouse with respect to which an election to use the DSUEA has been made.
  2. The returns has to continued to be open to IRS examination past the statute of limitations for the IRS to determine the proper amount of DSUEA.

Reasons Why Portability Doesn’t Make the Bypass Trust Obsolete

Prior to the portability concept, practitioners were limited to the use of qualified disclaimers to fully utilize the decedent’s applicable exclusion amount. But there are several reasons why portability doesn’t make the bypass trust obsolete.

  1. Generation-skipping transfer (GST) tax exemption isn’t portable.  A surviving spouse can’t use any unused GST tax exemption of a pre-deceased spouse.
  2. A bypass trust shelters any appreciation on the trust assets during the surviving spouse’s life from estate tax upon his or her death.
  3. There’s a risk of failure to make a timely election for the surviving spouse to use the DSUEA on the estate tax return.
  4. Because the deceased spouse’s returns continue to be open to IRS examination, there is no finality as to how much exemption the deceased spouse actually used, and the surviving spouse is subject to a time-consuming and costly re-examination by the IRS years after the deceased spouse’s death.
  5. Portability applies to the unused exclusion amount of the “last” deceased spouse of the surviving spouse and thus can’t have the unused exemptions be accumulated from several marriages. But there is no limit to the number of bypass trusts that can be created for one person.
  6. There are non-tax benefits of retaining property in trust rather than distributing it outright (ie. creditor protection and planning for disability).

Although the portability provision is a beneficial addition to the Internal Revenue Code, the bypass trust should not automatically be bypassed.