Do You (Really) Need a "Bypass"?

Lisa Nachmias Davis
Davis O'Sullivan & Priest LLC
129 Church Street, Suite 503
New Haven, CT 06510
Phone:  203-776-4400 / Fax 203-774-1060
davis@sharinglaw.net
(last updated 3/24/16)

     An estate plan for a couple sometimes includes trusts designed to minimize taxes, by "sheltering" assets from estate tax payable when the second person dies.  The plan is that assets of the first spouse to die "bypass" the second spouse and instead, go into a trust.   If you're a Connecticut couple with more than $2 million and don't have these trusts in your plan, you may need a bypass! 

      Why?  Although NO federal or (in almost all states) state estate tax is due when a person dies leaving assets to a U.S. citizen opposite-sex spouse (in CT: or same-sex spouse), the assets are then exposed to tax at the time of the surviving spouse's later death.  How much tax?  Amounts in excess of the federal exemption are now taxed at 35% and amounts in excess of CT's state exemption taxed at 7.2-15%.  In 2016, the federal exemption is $5.45 million or -- if steps are taken when one spouse dies -- $10.9 million.  In CT, the exemption is only $2 million, and other states' exemptions are lower. 

     If a Connecticut couple's COMBINED assets are under $2 million, no tax will be due when either dies, period. (Don't get me started on the probate fee, up to 0.5%...)  The tax is paid out of the estate or if there is no "estate" (no probate), by the people who get the money: your family. NO tax is due on amounts you leave to charity!  But suppose the couple's combined assets exceed these limits. Leaving aside federal estate tax, there is still exposure to CONNECTICUT estate tax for a couple with combined assets that exceed $2 million, because assets that pass to your surviving spouse will be taxed as part of that spouse's estate on that spouse's death.  

Example:  Ozzie has $2 million.  Harriet has $2 million of her own.  Ozzie dies leaving his $2 million to Harriet.  Harriet, grief-stricken, dies a year later.  She has $4 million -- her $2 M plus what she got from Ozzie.  On her death, the $4 million generates $146,400 in Connecticut estate tax. You can click here for a PDF table with the rates, or try my spreadsheet. (CAUTION:  CURRENT TO 4/22/12 only.)  Before the Bush tax cuts, there would be a substantial hit of federal estate tax, too -- even on amounts over $600,000.  Who knows what 2013 will bring at the federal level, but in Connecticut, Harriet can look forward to paying $146,400 for some time!

One way to show this is a kind of math equation:
OZZIE $2M + HARRIET $2M  =  HARRIET $4M
HARRIET $4M = FAMILY $3,853,600 + TAX $146,400

      This problem could have been solved if Ozzie's estate plan (will and/or trust) included a "bypass trust" AND he had assets in his sole name or the name of his own separate trust, that could be used to fund the bypass trust. His $2 million would have gone into the trust for Harriet so that when she died, the Bypass Trust would have owned $2 million and she, Harriet, would still have owned only $2 million. Trusts aren't people and don't die, so no more tax on the Bypass Trust assets.  Harriet would have had $2 million only -- no tax there either.  So if Ozzie and Harriet paid their lawyer $2,500 -$3,500 for this plan, they saved at least  $143,000! Pretty good deal!

So here is the solution:
OZZIE $2M + HARRIET $2M  =  BYPASS $2M + HARRIET $2M
BYPASS $2M + HARRIET $2M = FAMILY $4M


        Problems?

 (1) As noted -- to "bypass" Harriet, Ozzie's assets have to get into the Bypass Trust when Ozzie dies.  If Ozzie's $2 million consisted of his 401(k), this would have created complications.  There are very tricky rules about naming trusts and one false move can result in the whole 401(k) paying out over a short period of time.  Since traditional IRAs, 401ks, 403bs etc. are "pre-tax," estate tax can be pocket change compared with the INCOME TAX that is due on every dollar that comes OUT of the IRA, 401k and so forth.  It's usually preferable to leave these assets to the surviving spouse, period.

(2)  What if Ozzie and Harriet went to a lawyer who drew up a beautiful set of wills and Bypass Trusts for them and gave them instructions on keeping assets in separate names, but they forgot?  Instead, Ozzie and Harriet went home and put the lovely little folder of documents into the desk drawer and then went about their business.  When Ozzie died, the lawyer found out that all assets were titled in joint names.  A little eleventh-hour "disclaiming" might have fixed things, but unfortunately, Harriet had moved all the joint accounts to an account in her own name, and didn't talk to the lawyer until ten months had passed, so no "disclaiming" could be done.

(3) What if Ozzie had a plan like this, and $2 million in his own name, but Harriet had only $100,000?  Ozzie's entire $2 million would probably have gone into the Bypass Trust.  Since Harriet probably would spend $100,000 on expenses during her remaining lifetime, the plan would be more complicated than necessary.  Instead of saving $143,000, this plan would cost Ozzie and Harriet the original lawyer fee plus fees to administer the trust and more lawyer fees to undo the plan.

(4) What am I talking about -- what complications? What is a trust anyway?  CLICK for my article about what it means to be the beneficiary of a Bypass Trust rather than inheriting your spouse's estate outright.

Remember:  If you don't like the Bypass Trust, you have four alternatives: (1) spend the extra money during lifetime! (2) give it away each year in amounts that don't exceed $14,000 per donor, per donee, or qualify for the "med/ed" exclusion, so you don't die with more than $2 million; (3) don't worry about the Connecticut estate tax -- what's $146,400 in tax when you are leaving $4 million to your ungrateful kids; or (4) give the excess over $2 million to charity.  Actually there may be a few other tricks - consult a qualified estate planning attorney!

Note:  When it comes to the Bypass Trust, there may be as many variations as there are lawyers.  Even the name comes in different flavors.  Some lawyers call this type of estate plan an "A/B" plan, which means that the "A" part bypasses the surviving spouse and the "B" goes to a different kind of trust for the surviving spouse, and/or passes outright.  Some call it a "credit shelter" plan.  In some plans, the "marital" share (non-bypassing) goes outright to the spouse and everything else is held in trust.  In community property states, there may be a "Decedent's" trust and a "Survivor's" Trust.  The "Decedent's" community property half will bypass the survivor.  So:  if you see any of these terms you can feel pretty sure it is a "bypass" plan and the resulting trust is a "bypass" trust. 

WARNING -- these trusts do NOT help avoid paying for long-term care expenses and qualifying for Medicaid. I assume that if you have more than $2 million, you can afford to pay some of this for long-term care and/or purchase long-term care insurance -- but you should know that if your surviving spouse is the beneficiary of a Bypass Trust, the Connecticut Department of Social Services will treat the trust as fully available to meet your spouse's long-term care expenses - -the whole amount will in most cases have to be consumed before the beneficiary can qualify for Title 19.


CAUTION:  EVERYTHING I JUST WROTE HAS EXCEPTIONS AND FINE POINTS AND MAY CHANGE AT THE WHIM OF CONGRESS, THE STATE LEGISLATURE, ETC.  THIS IS A VERY GENERALIZED EXPLANATION. IT IS ABSOLUTELY ESSENTIAL THAT YOU MEET WITH YOUR OWN ATTORNEY AND PROVIDE YOUR ATTORNEY WITH FULL INFORMATION ABOUT WHAT YOU OWN AND THE WAY IT IS TITLED -- AND THAT YOU FOLLOW YOUR ATTORNEY'S INSTRUCTIONS!

DISCLAIMER: THIS INFORMATION IS NOT PROVIDED AS LEGAL ADVICE AND CREATES NO ATTORNEY-CLIENT RELATIONSHIP.
NO ENDORSEMENT IS INTENDED BY ANY REFERENCES HEREIN.
PLEASE CONSULT YOUR OWN LEGAL AND FINANCIAL ADVISORS BEFORE TAKING ANY ACTION

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