Tax and financial advice from the Silicon Valley expert.

Should you terminate a bypass trust in light of recent tax law changes?

The American Taxpayer Relief Act of 2012 passed on January 1, 2013, better known as the “fiscal cliff” tax legislation, includes provisions that dramatically change the tax planning environment for estate planning, including whether and how trusts will be used.

Most significantly, the lifetime exemption of $5 million, indexed for inflation ($5,250,000 for 2013) for a U.S. individual and the “portability” of the exemption of a deceased spouse were made “permanent.” Greatly oversimplified, this means a married couple currently can have a $10,500,000 combined estate and not be subject to federal estate tax. (The Obama administration has proposed reducing the exemption to $3,500,000 per person, or $7,000,000 for a married couple. Most families would still escape the federal estate tax with that exemption amount.)

Since the purpose of a “bypass trust” in an estate plan is principally to use the estate tax exemption of the first deceased spouse, the benefit has been greatly reduced for most families.

In addition, tax increases have been adopted that will seriously hurt trusts and estates. The new 39.6% maximum federal income tax rate (20% for long-term capital gains and qualified dividends) applies when estates or trusts have taxable income exceeding $11,950 for 2013. The new 3.8% (first effective for 2013) surtax on net investment income also applies at that point. (Almost all of the income of most trusts is investment income for the purposes of computing the net investment income tax.) These tax increases can possibly be avoided by currently distributing ordinary income to the beneficiaries, but capital gains generally aren’t distributable and are generally taxed to the trust or estate. (Distributed ordinary income is deducted on the income tax return for the estate or trust and reported as taxable income by the beneficiaries who receive the income.) Note the tax increase for long-term capital gains and qualified dividends has increased from 15% to 23.8%, almost a 59% increase!

But these trusts are irrevocable! Can they be terminated? Consult with your attorney. As I understand it, if all of the beneficiaries agree (each should consult with their own lawyer), a bypass trust can probably be terminated and usually distributed to the surviving spouse.

There is a side benefit of terminating a bypass trust. The assets of the trust may be eligible for a “stepped up basis” (provided they have appreciated) at the death of the surviving spouse.

On the other hand, a bypass trust can be used to “lock in” the current exemption amount for the first deceased spouse in case Congress reduces it later when that spouse is deceased when the current exemption is in effect.

Whether a trust should be terminated is more complex than just a tax question.

Assets held in an irrevocable trust are segregated from assets of the beneficiaries, so there is some protection from beneficiaries’ creditors. That protection will probably be lost if the assets are distributed.

The bypass trust document will indicate who the beneficiaries are for the income and ultimate distribution of the trust assets after the death of the surviving spouse. If the assets are distributed to the surviving spouse, the surviving spouse will control who the beneficiaries are. This can be a real problem when there are children from different marriages or relationships involved, or if the surviving spouse remarries.

Keeping a trust means having to pay fees for preparing annual income tax returns, legal counsel fees relating to fiduciary duties, and possibly expenses for providing accountings to beneficiaries.

If the trust is only distributed to the surviving spouse and the remainder beneficiaries release their interests in the assets, they will probably be deemed to have made reportable gifts of their remainder interests to the surviving spouse. The gifts may be applied to reduce their lifetime gift exemptions, $5,250,000 for 2013. Since the exemption is so large, there probably will be no gift tax liability, but gift tax returns should be filed. Depending on the circumstances and the applicable state law for the trust, the interest of a remainder beneficiary may be so contingent that no reportable gift will result. Alternatively, the trust may be distributed according to the ownership interests of the life and remainder beneficiaries so that no reportable gift results from the trust termination. See your tax advisor for details.

I’m not a lawyer, and the laws for trusts vary for different states. This is a serious decision that should only be made with legal counsel for each of the beneficiaries.

Everyone should make an appointment with their lawyer to review their current estate plan and old family estate plans.

Tax and financial advice from the Silicon Valley expert.