Before the American Taxpayer Relief Act of 2012, estate planning documents (Revocable Trusts and Wills) for many married couples included bypass planning language. This type of planning language captures the value of assets owned by the grantor spouse at death and creates a new Irrevocable Trust. The surviving spouse usually has a beneficial interest in the trust assets, such as net income, but does not have absolute ownership of the assets. These trusts are referred to by several names, including the family trust, credit shelter trust, bypass trust, or the residuary trust.
The assets captured using this planning strategy typically amount to the value of the federal estate tax exemption at the time of the grantor’s death. In the past, federal exemptions were completely forfeited if the spouse who died first distributed all assets outright to their surviving spouse at their death.
For many families whose main purpose of the “family trust” was to reduce or eliminate federal estate taxes, that benefit has been eliminated. Now that the current federal exemption is at $11,580,000 per spouse and includes spousal portability of the personal exemption, the trust may no longer be serving its original purpose.
Today less than one-tenth of one percent of estates are subject to Federal Estate Tax. Estate planning documents should be reviewed by an estate planning attorney to determine if changes are recommended to eliminate the bypass language in the current plan.
Can an existing family trust be terminated? Dumping the family trust will eliminate the annual costs of maintaining it. Annual costs of the trust could include tax preparation fees for the trust tax return, income tax, trustee fees, trust accounting fees or beneficiary notifications.
Arguments for Termination or Elimination
If all parties agree, including the trustee and the current and future beneficiaries, the trust could be terminated before the death of the surviving spouse. The advantages of doing this include:
- There will be no annual tax return to file, so no tax or preparation fees.
- If applicable, the trustee will no longer be obligated to comply with administrative rules such as accounting for net income, discretionary principal distributions or required notices.
- And the biggest argument for termination: the assets will get a step-up in basis at the surviving spouse’s death (assets in a bypass trust are not stepped up). Elimination of the capital gain tax liability from assets that were captured at the death of the first spouse could be significant if the family trust has been in existence for many years and the value of the trust has grown significantly.
Reasons Not To Terminate
The reasons to terminate may be compelling, but there are also solid reasons not to terminate a family trust, including:
- Eliminating the Family Trust requires complete ownership be transferred to the surviving spouse, so the spouse could decide to give the assets to someone other than the original beneficiaries of the Family Trust.
- If the spouse is married (or later remarries), these assets could be subject to the marital rights of the new spouse if not waived in writing with a pre-nuptial agreement.
- A typical bypass trust is protected from creditors of the beneficiaries.
- The Federal Exemption laws could change again.
- Cost – there will be costs incurred to eliminate the trust. Legal assistance is strongly advised and if there is little unrealized gains held in the family trust the cost and time involved to terminate may not add value.
- State Inheritance and Estate Rules may have lower exemption limits so those rules need to be considered.
Dumping the family trust may save families both administrative costs and income taxes. However, all factors should be taken into consideration and you should consult with your advisor and estate planning attorney before taking any action.
This is intended for informational purposes only and should not be construed as personalized investment, tax, or legal advice.