Legal Definitions - bypass trust

A bypass trust (also known as a credit shelter trust or an AB trust) is a sophisticated estate planning tool primarily used by married couples to minimize federal and/or state estate taxes. It is designed to ensure that both spouses can fully utilize their individual estate tax exemptions, potentially shielding a larger portion of their combined wealth from taxation when they pass away.

Here's how it generally works:

• When the first spouse dies, a portion of their assets, typically up to the current estate tax exemption amount, is transferred into an irrevocable trust, which is the bypass trust (sometimes referred to as "Trust B").
• The bypass trust is established for the benefit of beneficiaries other than the surviving spouse, most commonly their children or grandchildren.
• The surviving spouse usually has the right to receive income generated by the assets held within the bypass trust for their lifetime, but they do not control the principal (the main body of assets) and cannot change the ultimate beneficiaries.
• The remaining assets of the deceased spouse, along with all of the surviving spouse's own property, are typically placed into a separate trust (often called "Trust A" or the "marital trust") or remain directly owned by the surviving spouse, who retains full control over these assets.
• Upon the death of the second spouse, the assets held in both the bypass trust and the marital trust (or the surviving spouse's remaining assets) are distributed to their designated beneficiaries.

The key benefit of a bypass trust is that the assets held within it are not considered part of the surviving spouse's taxable estate when they die. This allows the first spouse's estate tax exemption to be fully utilized, "bypassing" inclusion in the second spouse's estate and thereby potentially reducing the overall estate tax liability for the couple's heirs.

While historically very common, the utility of bypass trusts for federal estate tax planning has diminished for many couples due to significant increases in the federal estate tax exemption and the introduction of "portability." Portability allows a surviving spouse to claim any unused federal estate tax exemption from their deceased spouse. However, bypass trusts can still be highly beneficial in specific situations, such as:

• For couples residing in states that impose their own estate or inheritance taxes, where state laws may not offer portability or have lower exemption amounts than federal law.
• When a spouse wishes to ensure that specific assets are preserved for particular beneficiaries (e.g., children from a previous marriage) and are protected from the surviving spouse's future decisions, creditors, or potential remarriage.
• To protect assets from potential future creditors of the surviving spouse.

Due to their complexity and associated administrative and legal fees, it is crucial for individuals considering a bypass trust to consult with an experienced estate planning attorney to determine if it aligns with their specific financial goals and family circumstances.

Examples of a Bypass Trust in Action:

• Scenario 1: Navigating State Estate Taxes
  Maria and David live in a state with a state-level estate tax exemption of $3 million, which is not portable. Their combined estate is $8 million. Federally, their estate is below the current high exemption, but at the state level, they could face significant taxes.

  When David passes away, $3 million of his assets are placed into a bypass trust for their children, with Maria receiving income from these assets for the rest of her life. This action fully utilizes David's state estate tax exemption. When Maria later dies, her estate consists of her own assets plus any remaining assets from David not placed in the bypass trust, totaling $5 million. She can then use her own $3 million state exemption, leaving only $2 million potentially subject to state estate tax. Without the bypass trust, David's $3 million would have passed directly to Maria, making her total estate $8 million, and potentially exposing $5 million to state estate tax after her exemption.

• Scenario 2: Protecting Inheritances in Blended Families
  Michael and Susan are in their second marriage. Michael has two adult children from his first marriage, and Susan has one. Michael wants to ensure that a specific portion of his wealth, including a family cabin, ultimately passes to his children, regardless of what happens after his death.

  Michael establishes a bypass trust in his will. Upon his death, the family cabin and a specified amount of his other assets are transferred into this trust for the benefit of his two children. Susan is granted the right to use the cabin during her lifetime and receives income from the trust's other assets. However, she cannot sell the cabin or change the ultimate beneficiaries of the trust. This ensures that when Susan eventually passes away, the cabin and the trust's principal will definitively go to Michael's children, fulfilling his wishes and preventing any potential redirection of these assets by Susan or a future spouse.

• Scenario 3: Asset Protection and Legacy Planning for High Net Worth
  The Chengs are a very wealthy couple with a combined estate well over the federal estate tax exemption. They own a significant portfolio of investment properties and want to ensure a portion of these assets is preserved for their grandchildren's education, protected from any potential future financial missteps by their surviving spouse or children.

  When Mr. Cheng dies, a substantial portion of his investment properties, up to the federal estate tax exemption amount, is placed into a bypass trust. Mrs. Cheng receives all the rental income from these properties for her lifetime, providing her with financial security. However, she cannot sell the properties or access the principal. This arrangement ensures that the value of these properties is locked in for their grandchildren's future education fund, protected from any unforeseen financial challenges Mrs. Cheng might face, or from being depleted by their children before reaching the grandchildren. The assets in the bypass trust are also excluded from Mrs. Cheng's taxable estate when she eventually passes, further reducing their overall estate tax burden.