Living With a Bypass Trust

Lisa Nachmias Davis
Davis O'Sullivan & Priest LLC
129 Church Street, Suite 805
New Haven, CT 06510
Phone:  203-776-4400 / Fax 203-774-1060
davis@sharinglaw.net

     TECHNICALLY, a trust is an arrangement between a grantor or settlor, who sets it up, and a Trustee, who runs it, to manage and distribute property, a "res" for the benefit of others, the "beneficiaries."  That's what we learn in law school.

     There are as many kinds of trusts as animals in the zoo. Maybe not quite so many, but too many to describe one by one!  This article describes a "Bypass Trust," part of a couple's estate plan designed to prevent assets owned by the first spouse to die from passing directly to the second spouse and being exposed to tax in the second spouse's estate.  See my explanation, "Do you need a Bypass?"

     In my Bypass article, I explained that if Ozzie and Harriet had $4 million between them, Ozzie's estate plan would leave "his" $2 million to a "Bypass Trust" for Harriet and the kids, rather than to Harriet, so that on her death she'd only have $2 million which would escape CT estate tax -- saving the heirs $146,400.  Any estate plan for Ozzie including a Bypass Trust would have these features:  (1) Harriet would be a beneficiary (not necessarily the only one); (2) Harriet could not hire and fire the Trustee unless the new Trustee would be someone "independent" from her; (3) if Harriet were herself the Trustee, her ability to take money out would be limited to "health, education and support" or "health, support, maintenance in reasonable comfort, education" or similar words (NOT loose words like "welfare"); (4) any ability the trust might give her to re-direct where the property would go at her death would exclude herself, her creditors, her estate, and the creditors of her estate; and (5) any right the document might give her to "withdraw" money for no reason, would be limited to the greater of $5,000 or 5% of the trust property.

      You'll notice that this is a list of "nots."  If any of these "no-nos" are violated, the trust could still wind up being taxed on Harriet's death, treated as her alter ego.  Some lawyers are so nervous about violating any of these no-nos that the Bypass trust document will require an Independent Trustee, will prevent Harriet ever firing the trustee, or will limit her to getting only income, or only money for "support."  Some lawyers may want to restrict Harriet's access so she won't "waste" the trust, which is protected from estate tax, rather than using her own property (which will be taxed when she dies).  And if it is a second marriage, or Ozzie wants to keep a little more control over what happens after he's gone, the trust might simply say that on Harriet's death what is left goes to the kids, period. 

      When I draft a Bypass Trust, subject to my clients' particular wishes, my starting assumption is that they want me to make it as painless as possible -- make Harriet feel that it is as close as I can possibly get to having her own the property herself, outright, without resulting in the property being taxed when she dies.   Subject to the "no-no" list, my documents will allow Harriet to fire the Trustee, will allow Harriet to adjust for changing circumstances by somewhat re-arranging what happens to the money when she dies (known as a "power of appointment"), allow her to take out 5% per year for any reason, although only at the end of the year -- I'll explain that if you ask me -- and allow Harriet to be her own Trustee, although if she wants money for something other than "heath, education and support" she has to get an Independent Trustee as co-Trustee to make the decision.  That's where I start, but I make changes to fit each client's circumstances.

      As with any trust, the Trustee of a Bypass Trust is supposed to act with reasonable care and prudence, inveseting sensibly, balancing the interests of the beneficiaries; may be required to account for what is done with the trust property (show the books, do a financial statement); must file tax returns; may be hauled into probate court and fired by the judge if accused of stealing or neglect.  As with any trust, the trust assets are managed for the benefit of certain beneficiaries (Harriet) and on the life beneficiary's death, pass to remainder beneficiaries. 

      Suppose Ozzie dies, and Harriet finds herself the beneficiary of the Ozzie Bypass Trust.  She is the Trustee.  As Trustee, with the help of the lawyer or accountant, she will get a separate tax identification number for the trust -- like a Social Security number.  She'll have to go to the bank or brokerage , and arrange for everything Ozzie had that passed to the trust when his estate was settled to be re-titled in the name of the trust. The interest and dividends that the trust earns will be reported to the IRS as being income of the trust. This means that the trust must file its own tax return every year, IRS Form 1041, and pay its own tax, EXCEPT that if it distributes out interest and dividends, it gets a tax deduction for this and the amount passed out is reported by Harriet (or whoever got the money). 

     As Trustee, Harriet pays herself the income; as beneficiary she receives it. In other words, as Trustee she writes a check on the Trust's bank account or CMA account at the brokerage, and deposits it in her own bank account.  She talks to the accountant to figure out just what has to come out of the Trust account each year to keep the Trust's income taxes low. In addition, as Trustee, she can pay more to herself as beneficiary, provided it is for things like property taxes, or food, or utilities, or health insurance premiums or copays and deductibles, or dentist bills, or taking a course at the local college.  If she wants to take trust money to go on a cruise, set up a charitable foundation, go to the casino, she'd have to resign as Trustee, or add a co-Trustee who could decide if that was a prudent and appropriate thing for the trust to do.  In Connecticut, she does not have to file reports with the children -- the remainder beneficiaries -- but if the children think she is abusing her Trustee position, they do have the legal right to demand information, take her to court, or ask the judge to remove her.  If I wote the trust, she'd also be able to make gifts to the children out of the trust funds, by "appointing" property to them during her lifetime, or making distributions to them for their needs.

      What if Harriet isn't the trustee any more? In that case, she would talk to the Trustee about her needs and the Trustee would arrange to pay them.  She'd have to persuade the Trustee she really needed money from the trust (unless it mandates that she get the income), since the Trustee would have to worry about the children suing him or her if the trust assets were depleted by the time of her death.  The Trustee would make distributions in the Trustee's "discretion."  If I prepared the Trust, she'd at least have the ability to name new Trustees if the Trustee resigns, and/or to fire the Trustee.  (Only if she BOTH fires the Trustee AND puts in a new one, would she have to pick someone truly independent.)

      So -- DEPENDING ON HOW THE TRUST IS WRITTEN -- being the beneficiary of a Bypass Trust may involve extra complications, paperwork, and tax returns, but remain relatively painless -- while saving the kids six figures in state taxes. Not bad!  The devil is in the details:  what does the trust document actually say?  Remember to read the document closely and to ask your lawyer questions about the limits and requirements.

    WARNING -- these trusts do NOT help anyone qualify for Medicaid to avoid paying for long-term care expenses. 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 you are already beneficiary of a Bypass Trust, even though the IRS won't consider this part of your "estate," the Connecticut Department of Social Services will - - the whole amount will in most cases have to be consumed before you, 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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