Bypass trusts, or B trusts, have long been used as a strategy to help families avoid estate taxes. But with recent changes in income tax and estate tax rates, in many cases B trusts now trigger substantially higher capital gains taxes for beneficiaries or heirs without providing any estate tax savings.
An existing B trust can be a ticking time bomb, detonating after the death of the surviving spouse. Private wealth professionals should advise clients with existing B trusts to review their situation with their tax attorney or estate planner to see if corrective action is needed.
Only a few years ago, the estate tax exemption was $675,000 and the federal estate tax was as high as 55 percent. Estate planners, concerned with minimizing estate tax, turned to A-B trusts using a marital deduction formula. Most marital formulas provide that the surviving spouse’s one-half of community property interest and all of his or her separate property be allocated into the A trust. The survivor has unrestricted access to the income and principal of the A trust. All of the deceased spouse’s separate property, as well as one-half of his or her community property, is allocated to the B trust. Upon the surviving spouse’s death, the beneficiaries or heirs receive a step-up or increase in income tax basis to prevent or minimize the capital gains tax liability.
The concern for beneficiaries is that the B trust is irrevocable and, in most cases, significantly limits the surviving spouse’s access to the deceased spouse’s one-half community property interest in the trust assets. The utility of B trusts has come into question because of new estate tax rates. Today, the marital formula provisions found in these trusts can have disastrous consequences for the surviving spouse and for beneficiaries and heirs.
In 2013, the income tax and estate tax rates changed dramatically. Each person now has a $5.43 million estate tax exemption. That exemption is expected to increase to $5.45 million in 2016, which means that less than 0.2% of the U.S. population will be subject to estate tax. Very few individuals still need that estate tax exemption. However, we all pay income taxes, and those rates increased substantially in 2013 as well. In California, the highest marginal rate for capital gains is 37.1%. The capital gains tax is often one-third or more of the total gain.