Bypass or Credit Shelter Trusts
The bypass trust, which is also referred to as a credit shelter trust, is one of the common types of trusts. It is used to eliminate or reduce federal estate taxes and is typically used by a married couple whose estate exceeds the applicable exclusion amount that is exempt from federal estate tax.
Every individual is entitled to a unified tax credit which is applied against gift and estate tax liabilities. This credit exempts an "applicable exclusion amount" from estate and gift taxes. The applicable exclusion amount—the amount exempt from gift and estate tax—is $5,12 million in 2012 and $5.25 million in 2013.
Of course, a married person may leave an unlimited amount of assets to his or her spouse, free of estate taxes and without using up any of the unified tax credit. The problem is that if the second spouse later dies with an estate worth more than the applicable exclusion amount, his or her estate will be subject to estate tax. Meanwhile, the tax liability of the second spouse could have been avoided had the first spouse taken advantage of the unified tax credit which, instead, went unused and wasted. In years after 201, the second-to-die spouse can also claim any unused applicable exclusion amount of the first to die spouse--provided the appropriate election is made on the Form 706.
The bypass trust was created to take care of this problem. This trust continues to be an important estate planning tool, as discussed in an earlier article. This type of trust may be revocable or irrevocable, and living or testamentary. Typically, the trust instrument initially creates a single living trust that is revocable.
Upon the death of the first spouse, the trust instrument establishes a separate, irrevocable "bypass" trust into which trust assets belonging to the deceased spouse can be deposited. The surviving spouse is set up as the life-interest beneficiary of this trust, with the children as beneficiaries of the remainder interest.
The irrevocable trust is funded to the extent of the deceased spouse's applicable exclusion amount $5.12 million in 2012 and $5.25 million in 2013. Because the trust takes full advantage of the deceased's applicable exclusion amount, the amount in the irrevocable trust is not subject to estate taxes on the death of the first spouse.
At the same time, special language is used in the irrevocable trust so that the assets in the irrevocable trust will not be included in the taxable estate of the beneficiary (i.e., the surviving spouse). Generally this involves giving the surviving spouse only limited powers to control the trust assets. Thus, the bypass trust is aptly named, as the assets in the irrevocable trust "bypass" the estate tax that would be assessed upon the death of the second spouse.
Tip
Beginning in 2013, a new 3.8 percent net investment income tax may be imposed on individuals whose modified adjusted gross income exceeds $250,000 for joint filers, $125,000 for married taxpayers filing separately, and $200,000 for others. Trusts and estates with income over a certain amount are also subject to the NII tax. Form 8960, Net Investment Income Tax - Individuals, Estates, and Trusts is attached to the tax return. For 2013, the IRS has provided taxpayers the ability to rely on more than one set of net investment income tax rules. The best choice varies by taxpayers and depends on the taxpayer's unique situation. Consult your advisor to determine which approach would be best for you.
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