Bypassing the Bypass Trust

February 22, 2018

By Eileen F. Sheridan, CPA, MST and Michele R. Shipp, Esq.

There was a time when $22 million was a lot of money. Now, for a married couple, it’s considered a “small estate,” which is what estate planning practitioners refer to when the taxable estate value is below the lifetime exclusion amount. If the couple had a “large estate” (more that $22.4 million in 2018,) then there would be estate tax due when the second spouse passes away. 

Under the Tax Cuts and Jobs Act, it’s especially important for CPAs to suggest an estate plan review so the client is not left with an outdated estate planning structure that creates more administrative burdens with less tax planning benefits. While solutions are available when planning opportunities are missed, they may come at a cost. 

Typical A/B Trust
What happens if the first spouse dies, but estate planning documents haven’t been updated to reflect the significant increase to the lifetime basic exclusion amount of 
$11.2 million per individual in 2018? 

Previously, when exclusion amounts were much lower and portability did not exist, trusts for married couples with small estates were drafted to require creating a survivor’s trust and a bypass trust at the first settlor’s death. This drafting approach was appropriate when the objective was to exclude appreciating assets from the survivor’s estate at his or her death. But, funding highly appreciating assets into a bypass trust can cause a lost opportunity for receiving a step-up in basis at the second death without the benefit of saving any estate tax. This is especially true when there’s a lengthy time horizon between the first and second death. 

However, the bypass trust still may be useful for blended families, creditor protection planning and other situations, so it should be evaluated accordingly. 

Strategies for Avoiding a Bypass Trust
Spouse No. 1 has died and the trust is irrevocable! What can be done? 

The following are some post-mortem planning solutions for the surviving spouse when a bypass trust is mandatory, but no longer offers estate tax planning benefits. In all solutions, the assumption is made that all beneficiaries are treated the same for both the survivor’s trust and the bypass trust.

Option 1: Petition the Court
Under California Probate Code Sec. 15403, if all beneficiaries agree, a trustee or beneficiary of an irrevocable trust may compel modification or termination of the trust upon petition to the court. The challenge with this approach is identifying all the beneficiaries and, if there are minors or unborn beneficiaries, there may be additional steps to ensure their legal rights are adequately represented. The court may have discretion on whether to grant such requests even with a unanimous beneficiary agreement.

If the beneficiaries are not in agreement, then relief may be available under California Probate Code Sec. 15409 due to a change of circumstances not anticipated by the settlor.

Option 2: Private Party Agreement 
(No Court Order)
The parties can agree that the trustee will not have to fund the bypass trust. This could be a viable solution unless objections are raised later.
If the beneficiaries require further assurance, the surviving spouse can agree to restrict her authority over the survivor’s trust by requiring beneficiary consent. For example, consent could be needed prior to altering distribution standards, making charitable gifts and paying expenses over a certain dollar amount—all things not normally seen in a typical, revocable survivor’s trust. 

However, the fiduciary will remain exposed to future claims by not obtaining a court order. 

Option 3: Make QTIP Election on Bypass Trust
If the terms of the bypass trust contain the key provisions to allow it to qualify as a marital trust, a QTIP election can be made on Form 706 and the assets would get a step-up in basis on the second death.

Option 4: Do Nothing! 
This option is simple, but risky. Periodic reviews can evaluate whether the bypass trust should be funded at a later time based on the size of the estate, asset appreciation and tax law. It’s difficult to give this guidance to clients, but the risk is relative when the surviving spouse is older, has an estate in the $1 million to 
$3 million range and no complexities exist, such as a blended family. Clients can, and do, choose this option as many simply don’t want to incur the cost of the options mentioned above. As always, it’s best to document the CPA/client discussion regarding any risks and decisions and maintain those records indefinitely.

Planning for the Unknown
While the couple are both still alive, annual estate planning reviews will help identify these issues earlier and trust provisions can be amended to offer more planning flexibility. For example: 
  • The most flexible planning design is to give the surviving spouse the option to disclaim assets, which would then fund the bypass trust. This optional A/B split offers the trustee time to determine if the greater tax benefit is avoiding estate tax or receiving a full step-up in basis at the second death. It’s important to work with the attorney on the specific requirements and timing for making a qualified disclaimer under IRC Sec. 2518. 
  • For larger estates, a Clayton Contingent QTIP provision [(Estate of Clayton v. Commissioner, 976 F2d 1486 (5th Cir. 1992)] can provide even more flexibility. At the first death, this provision allows the trustee to select assets for the QTIP. Any other assets not selected will automatically be funded into a bypass trust. This approach allows the trustee more time to identify which assets are suitable for each trust based on the current economic conditions and ongoing tax reform. The trustee will then make a QTIP election only for the assets selected for the QTIP trust to receive the full step-up in basis at the second death. 
The Unwanted Bypass Trust
What if it’s too late? If the bypass trust has already been funded and there’s now a desire to terminate it so the assets will obtain a new basis upon the death of the surviving spouse—and assuming no power to terminate is authorized under the governing instrument—a trustee or beneficiary may petition the court to do so, especially if the value of the trust principal is low in relation to the cost of administration (CA Probate Code 15408). 

There are also strategies for spending down a bypass trust to reach this threshold requirement. For example, a trustee may exercise its discretion to make principal distributions and accelerate the spending down of corpus (i.e. terminating distribution). 

These strategies will not apply in every circumstance and termination may not be possible. For example, if the trust has been in existence for many years and contains assets that cannot easily be spent down, such as partnership interests with a healthy cash flow. The trust simply may not be able to be terminated and the second step-up will be unavailable.

Estate planning advisers are in a unique position to help clients plan ahead by finding opportunities for greater flexibility through the changing tax laws and life circumstances. The increase to the exclusion amounts from the Tax Cuts and Jobs Act is set to expire after 2025, so tax reform will continue to be on the horizon. If and when we revert back to a $5 million exclusion amount, the small estates will instantaneously become large estates again!
Eileen F. Sheridan, CPA is a partner and Michele R. Shipp, Esq. is a senior accountant at Bartlett, Pringle & Wolf, LLP. 
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