Dianne Reis, attorney at law.

Board Certified - Estate Planning and Probate Law
Texas Board of Legal Specialization

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Questions Discussion
Why do I need a will?
Is probate really that bad?
Do I need a living trust?
Can my estate avoid paying an executor's fee?
How can I save estate taxes?
What is a bypass trust?
What is a life insurance trust?
What is a Crummey trust?
What is the difference between community property and separate property?
What taxes will the beneficiary of my life insurance policy have to pay?
What's the difference between an inheritance tax and an estate tax?
Who will get my property if I die without a will?

What is a Bypass Trust?

Please remember that this answer is provided in the spirit of public education, not as legal advice. If you require legal advice for a particular situation, you should consult an attorney.

A bypass trust is a long-term planning device. If you leave property to someone in the form of a bypass trust, that property will not be subject to estate taxes when that person dies. (The property will still be taxed in your estate, however; to save tax in your own estate, other methods must be used.)

A bypass trust is particularly useful for spouses who plan their estates together. By leaving property to each other in bypass trust form, they can guarantee that the property will only be taxed once between the two of them.

To effectively save taxes, a bypass trust must follow certain rules laid out by the IRS. Let's suppose your will sets up a bypass trust for your husband, and you die first. In order to keep the trust from being subject to estate tax when your husband dies, your will must place the following conditions on the trust:

1. You must limit your husband's power to access the trust during his lifetime.

Your husband must not have an unrestricted right to withdraw principal. However, you can give him the right to withdraw principal to provide for his health, education, maintenance, or support, and you can also give him the right to withdraw up to $5,000 of principal per year for any purpose, or 5% of the total principal, whichever is greater.

You can also give him the right to all of the interest and dividends earned in the trust each year, and you can appoint him trustee. As trustee, he would have full discretion to decide whether principal is needed for his "maintenance" or "support." Thus, this condition is ultimately quite flexible.

2. You must limit your husband's power to distribute trust assets upon his death.

Except as provided above, your husband cannot have the right to give the trust assets to himself, his creditors, his estate, or his estate's creditors. You can, however, give him the right to name in his will specific persons who will succeed to the trust upon his death. For example, you could authorize him to leave the trust to any of your nieces and nephews, or to divide it as he pleases among your children. Alternately, you can specify who gets the trust next and leave him no discretion.

Although a bypass trust can be very flexible in practice, it is critical that the trust be drafted with absolute precision. The IRS has specified the words that may be used in a bypass trust, and if these words aren't duplicated perfectly, the trust might not be excluded from tax in the second estate. Even the slightest drafting error can cost over a million dollars in taxes, so be sure your bypass trust is being drafted by an attorney who is knowledgeable about federal tax law.

 

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