Executive Summary
Planning around estate taxes by using a Bypass Trust is a "basic" strategy that has been around for decades. In fact, for many clients, it was a major impetus to get their estate planning done in the first place - if your estate was above a certain threshold and you didn't get estate documents that would put a proper Bypass Trust in place, it could cost your beneficiaries hundreds of thousands of dollars.
Yet with the new provisions of the tax legislation signed into law last week by President Obama, Bypass Trusts will no longer be necessary for many clients to maximize the use of a couple's estate tax exemptions - which means it may be time to bypass the Bypass Trust planning strategy.
To understand why Bypass Trusts may no longer be necessary, it may be helpful to take a step back and understand why they have been necessary in the past. Under the estate tax law that has been in place for the past few decades (excluding the unusual provisions in place for 2010), every individual is eligible for an estate tax exemption - a certain amount that can pass under their estate free of any estate taxes. This amount has varied from $600,000 up to $3.5 million from 2000 to 2009, and is now scheduled to rise to $5 million in 2011.
When an individual passes away, this is relatively straightforward. If your client died in 2009 and had less than $3.5 million, the entire amount could pass to anyone, free of estate taxes because the entire estate would be covered by the exemption.
With a married couple, though, it was a little more complicated. If each member of the couple had $3.5 million, and the husband passed away and left everything to his wife, the wife would now have a $7 million estate, but at her death there would only be a $3.5 million exemption. Thus, sequential deaths of the couple could lead to a tax as high as 45% (in 2009) on the last $3.5 million in the wife's estate.
The workaround was a Bypass Trust. The husband's estate documents would be altered so that instead of leaving his money to his wife, he would leave it to a separate trust (although the trust could be established primarily for his wife's benefit as long as she was still alive). By leaving the money not to his wife, but to a trust, and by putting restrictions on that trust, the couple could ensure that even if the husband died first, the wife would only face estate taxes on her OWN assets and not those inherited from her husband - because she didn't actually receive the assets from her husband, they went to a Bypass Trust instead! The net result - at the wife's second death, she would own her assets (hopefully still below the estate tax exemption amount), her husband's assets would be in a trust that she has limited access to and thus doesn't need to include in her estate (although she may still have access to the income or even limited access to the principal for her needs while alive), and thus her husband's assets would "bypass" her estate and any estate taxes.
However, this all changes because of an important provision in the new tax legislation: estate tax exemption portability. Simply put, under the new law to take effect for 2011, when the first member of the couple passes away, the surviving spouse inherits the deceased spouse's estate tax exemption; so in our earlier example, when the husband passes away, the wife inherits not only her husband's $3.5 million of assets (bringing her total to $7 million) but also inherits her husband's estate tax exemption of $3.5 million (bringing her total exemption to $7 million). The net result: even without a bypass trust, the entire estate is exempt from estate taxes at the second death of the couple. (Note: These exemptions will rise from the $3.5 million amount in 2009 to $5 million in 2011, along with the implementation of the new portability rules.)
So as a result of the legislation, many couples will no longer need Bypass Trusts. Simply leaving everything you own to your spouse can be just as effective to preserve the first spouse's estate tax exemption! Of course, many couples may still wish to explore trust planning for other reasons, including asset protection, controlling where assets go after death, limiting a surviving spouse's access to assets, or for generation-skipping-trust planning (while the estate tax exemption will be portable, the GST exemption will not). But for a very large number of clients, simple "I Love You" Wills (as in, "Honey, I love you, and I leave you everything") will be sufficient to cover the bulk of their estate tax planning.
For financial planners, this may ultimately lead down one of two paths. On the one hand, this is good news; estate planning just got simpler, and now you can spend more time in the estate planning process talking about where couples actually WANT their money to go after their death and how they want it managed, rather than being forced to spend a great deal of time talking about "complex" trusts solely for the purposes of working around the estate tax exemptions. On the other hand, the reality is that many clients drag their feet when faced with estate planning - to say the least, it's a rather morbid topic to consider! - and one of the few motivations to really get it done was the fact that their heirs could face hundreds of thousands of dollars of estate taxes if they didn't act. Without the threat of significant estate taxation looming, will it be even harder to get clients to act?
Of course, there are still some details to sort out. Basic provisions are in place under the law to prevent some abuses - no, you can't just keep marrying new people to collect a whole pile of estate tax exemptions - but more clarification on some of the finer points of the provisions are still forthcoming. And for states that still have a state estate tax - especially one decoupled from the Federal limits - some Bypass Trust planning may still be necessary to manage the state burden (at least until states adjust their rules to conform). But nonetheless, for a whole lot of people who previously required Bypass Trusts to manage their estate tax exposure, the strategy is just no longer necessary.
So what do you think? Will estate planning be easier with your clients now that the estate tax exemption is portable? Will this allow you to spend more time talking about positive reasons to use trusts for planning purposes, rather than having the tax tail wag the estate planning dog? Or will it be harder than ever to get clients to plan, now that the looming estate tax impact is no longer necessarily a motivator anymore?
I believe that the portability provision sunsets on 1/1/2013??
Don’t die in New Jersey. The State decoupled from the Federal Estate Tax rules and also has a separate Inheritance Tax.
You can’t even die for free.
As I understand it, to port an unused estate tax exemptiont
the decedent’s representative must file a federal estate
tax return and make an affirmative election.
For this reason I fear a lot of unused exemptions will not
be ported.