The use of a bypass trust has been a staple in the estate planner’s toolbox for decades. For a good reason, too. While many of those reasons are still valid, some have changed. For example, bypass trusts were used to have a decedent’s estate bypass the survivor’s estate to fully maximize the decedent’s estate tax exemption amount. With the estate tax exemption amount so high, having a bypass trust for this reason may be a moot point, now. Additionally, bypass trusts can be less tax efficient than some other strategies. The remainder of this post will examine the bypass trust strategy and four tax inefficiencies.
Step up in cost basis
When a taxpayer passes away, their beneficiaries receive a step up in cost basis. For example, a taxpayer paid $500,000 for a stock portfolio, and it was worth $1 million when he passed it along to his kids at his death. His kids’ cost basis will be $1 million. If they sell the stock portfolio immediately for $1 million, they will not owe any taxes.
Unfortunately, assets in a bypass trust are not afforded the same treatment. When the surviving spouse passes away, the assets in the bypass trust will not receive a second step up in cost basis. For example, a decedent passes away, and their estate is put into a bypass trust. The decedent had a $1 million portfolio at the time of their death so the bypass trust’s cost basis is $1 million. The surviving spouse continues to receive dividends from the bypass trust for the remainder of their life, and the portfolio grows to $1.5 million at the time of the survivor’s death. Now, their kids inherit the assets, and they would owe capital gains tax on the $500,000 of growth in the bypass trust
Trust tax brackets
Bypass trusts are separate taxpaying entities. Unfortunately, their tax brackets are much more compressed with the highest tax bracket of 37% being reached at just $12,950 of income. When income is earned, bypass trusts can distribute the income to the beneficiary. The income retains its character, and the trust is allowed a deduction for income actually distributed.
What’s the problem then if the income can be distributed and taxed at individual rates? If a trust is silent on whether capital gains are income or principal, the default treatment of capital gains is principal. Trusts can designate capital gains as income or principal, and if income treatment is chosen, this would supersede the default. Trusts can also give the trustee discretion to decide how capital gains should be treated. If the default treatment is in place due to silence on the issue, then the trust does not get the deduction for the capital gains distribution, and the capital gains would be taxable at the trust’s less favorable rates.
Section 1244 and 121 treatment
Bypass trusts are not given Section 1244 treatment on the disposition of Section 1244 stock. Additionally, section 121 capital gain exclusion on primary residence is not awarded to bypass trusts. These scenarios are probably less common than the previous tax issues, and these code sections are more of a one time deal rather than an annual distribution. Let’s take a look at an example.
A single taxpayer sells his primary residence for $500,000. He paid $300,000 for the residence five years ago. He meets the qualifications for section 121 and does not need to pay capital gains tax on the $200,000 gain. A bypass trust would need to pay capital gains if it owned this residence and sold it.
Section 1244 allows taxpayers to take a $50,000 or $100,000 (depending on tax filing status) ordinary loss on the sale of qualifying small business stock. If a bypass trust owns this type of stock, it cannot take the same ordinary loss.
Tax Planning Opportunities
A popular estate planning strategy is to put all of a married couple’s assets into a revocable trust, and upon the first spouse’s death, the decedent’s estate is placed into a bypass trust. The survivor’s estate is put into a marital trust. If the trust document allows the trustee to decide which assets to place into which trust, the trustee could determine where to place assets for the most favorable tax treatment assuming the remainder beneficiary of each trust is not negatively impacted. For example, a trustee may choose to avoid putting a primary residence in the bypass trust to ensure they do not miss out on potential section 121 exclusion.
If all beneficiaries are okay with it, another tax planning opportunity is to make sure the trust document allows capital gains to be treated as income allowed to be distributed. If all else fails, trustees and beneficiaries may want to consider if it is beneficial tax wise to distribute all bypass trust assets.
Conclusion
As with most scenarios, there are tax and nontax reasons to implement strategies. All things should be considered when deciding what estate planning techniques to employ. While the estate tax exemption is currently high, laws change, and bypass trusts could be helpful again to decrease estate taxes.
Disclosure
Strategic Insights Financial Planning Group and LPL Financial do not provide legal advice or services. Please consult your legal advisor regarding your specific situation.
LPL Financial Representatives offer access to Trust Services through The Private Trust Company N.A., an affiliate of LPL Financial.