Recently, the “American Taxpayer Relief Act,” was enacted, which has permanently enlarged the estate tax exemption to $5,250,000 per person (for 2013). It also permits a married couple to effectively double their exemption even without special estate tax planning.
By comparison, before this, when you created your trust the estate tax exemption was much smaller, and special tax planning was required to minimize estate taxes. I usually would have recommended a form of trust, usually a Living Trust with a Bypass Sub-Trust built into it, which would have paid attention to the lower estate tax exemption. A Bypass Sub-Trust has also been known as a “B Trust,” an "Exemption Trust", a "Family Trust", and/or a "Credit Shelter Trust".
Bypass Trusts typically require that, on the death of the first spouse, a share of the couple’s assets be transferred into an irrevocable sub-trust called the “Bypass Trust”, rather than to the survivor directly. This preserves the first spouse’s estate tax exemption for later use at the survivor’s death. Without the Bypass, the first spouse’s exemption could potentially be unclaimed and lost and all trust assets at the survivor’s death would be sheltered by only the survivor’s one exemption and the excess (if any) was exposed to an estate tax at a rate as high as 55%. Understandably, couples went to great lengths to avoid that tax.
However, Bypass Trusts often presented its own set of issues, such as: (1) not taking into consideration change in family circumstances, and the Bypass Trust would prevent the survivor to lose the right to make any changes despite this; (2) restrictions on the survivor’s access to the Bypass assets; (3) problematic when applying for cerain long-term care benefits; and (4) it usually required the preparation of separate accounting and income tax returns during the lifetime of the survivor. Thereby, surviving spouses typically found the restrictions overly burdensome.
Two important new developments arrived with the new law: (a) as of 2013, the amount of the estate tax exemption has now permanently increased to $5,250,000 per person, to be annually adjusted for inflation, and (b) the unused portion of the first spouse’s full exemption is now preserved for use by the second spouse even without the use of the restrictive Bypass Trust, effectively doubling the exemption for most couples.
In view of these new developments, couples with Bypass Trusts created for estate tax purposes under the old law should have their trusts reviewed and, where appropriate, consider eliminating the mandatory funding feature at the first spouse’s death. Instead, they might now consider plans which give the survivor the option of doing postmortem planning after the first death, e.g. by funding a portion of trust assets into an optional Disclaimer Trust. The Disclaimer Trust would then operate as a tax-saving Bypass Trust if that later appeared necessary due to the increase in value of the couple’s estate.
In that sense, I suppose you could say that the Bypass Trust has gone the way of the Dinosaur for most middle income estate plans, where it is unlikely that the couple’s estate would ever exceed two exemptions, i.e. $10,500,000 (for persons dying in 2013), and inflation indexed thereafter.
An exception to the above recommendation: The use of the mandatory Bypass Trust is still useful for non-tax purposes, e.g. in situations involving second marriages. Here, each spouse usually wishes to provide financial security for the survivor, but also wishes to preserve a portion of assets for his/her own children. Under these circumstances, a Bypass Trust can still help these couples achieve their estate planning goals.