There are both temporary and permanent rules for federal estate planning. These principles are helpful in creating estate plans, but it is important to understand the potential future changes.
Estate Exemption – For the years 2018 through 2025, the applicable exclusion is in excess of $10 million, indexed for inflation. Thereafter, it will revert to $5 million per estate plus inflationary adjustments. This amount also applies to gifts and to generation skipping transfer taxes.
Estate Tax Rate – Those estates over the exclusion amount will be taxed at 40%. Estate tax equals $345,800 on the first $1,000,000 and 40% of the excess over that amount, reduced by the credit on the applicable exclusion amount. This amount for 2023 is calculated based on a $12.92 million estate and the estate tax that would be payable without the applicable exclusion would be $5,113,800. The $12.92 million number will be adjusted for inflation in future years.
Marital Portability – Under "marital portability," a surviving spouse may have both exclusion amounts available. The applicable exclusion amount for a surviving spouse will be the basic exclusion amount with cost of living increment plus the "deceased spousal unused exclusion amount." The unused exclusion will be the exclusion amount of the deceased spouse in excess of the basic exclusion amount used in the estate of that spouse. The unused exclusion amount will not be adjusted further for inflation. In order to benefit from this provision, the executor must make an irrevocable election on the federal estate tax return of the deceased spouse.
If the deceased spouse transfers all assets to the surviving spouse using the unlimited marital deduction, then the surviving spouse should have available the full value of both exclusions. The amount of exclusion cannot exceed twice the basic exclusion amount and only the remaining exclusion of the last deceased spouse may be utilized.
Gift Taxes – There are two exclusions for gifts during life. Present interest gifts qualify for a $17,000 (in 2023) annual exclusion. This gift exclusion is intended to cover birthday, holiday and other gifts. There is one exclusion for each donor and each donee. For example, a couple with two children may give up to $68,000 to their children in 2023 by using four gift exclusions.
Each person also has a lifetime gift exclusion amount equal to the estate exclusion amount for that year. If the gifts exceed annual exclusion amounts, the balance will be reported on the IRS Gift Tax Return Form 709. The amount of gifts reported on Form 709 will reduce the available estate exemption. Gifts in excess of both the annual exclusions and the lifetime gift applicable exclusion amount will be subject to a 40% gift tax.
Generation Skipping Tax – If a donor transfers property to a grandchild during life or through an estate, there is potentially another transfer tax. The generation skipping tax (GST) is 40% on transfers to grandchildren or great-grandchildren that exceed the GST applicable exclusion amount. This GST exclusion is the same as the estate exclusion amount for the year of the transfer.
Because there is an estate tax with an exemption of $12.92 million in 2023, it will continue to be important for individuals with large estates to create "bypass trusts." The bypass trust is a trust created in the estate of the first spouse to die. It typically will benefit the surviving spouse and the trust principal may then be transferred to children without further estate taxation.
There are two general types of bypass trusts. The conventional bypass trust pays income to the surviving spouse. When he or she passes away, the trust is distributed to children. For individuals who have large IRAs, 401Ks or other qualified pension plans, another option is a "bypass charitable remainder trust."
Bypass Trust Potential Tax Savings
For a couple with larger assets, a bypass trust is created in the estate of the first spouse to pass away. It is typically funded with the amount of the estate exemption. The bypass trust saves future estate tax because the tax in the first estate is offset by the exemption of the first spouse. Because the bypass trust is subject to tax in the first estate (but covered by the estate exemption), it is not taxable in the second estate. While the portability of the marital deduction permits the first spouse to use a simple will and transfer assets to the surviving spouse, a bypass trust permits the appreciation of trust assets during the lifetime of surviving spouse to escape taxation. The savings on this appreciation could be quite substantial in a larger estate.
Assume that there is a $12.92 million exemption per person and Joe and Jane have a $25.84 million estate. They have a simple will with all to the survivor. Joe passes away and transfers his half of the estate to Jane. She then owns all $25.84 million in assets. There is no tax because of the unlimited marital deduction. Joe's executor elects to pass to Jane the $12.92 million "deceased spouse unused exemption amount (DSUEA)."
In the years before Jane's death, the estate grew to $28 million and Jane's exemption increased from $12.92 million to $14 million. When Jane passes away, her exemption plus the DSUEA total $26.92 million. However, the estate is $28 million, so $1.08 million of her estate is taxable. The estate tax is equal to 40% of the taxable amount or $432,000.
Bill and Betty also have a $25.84 million estate. However, both of them create plans with a bypass trust. Bill passes away in 2023 and his entire $12.92 million estate is transferred to a bypass trust. The trust is exempt because of the $12.92 million estate exemption. Therefore, Bill's estate pays no estate tax. Betty receives income from the bypass trust for her lifetime. When she passes away, the bypass trust and her estate are each $14 million. Only her estate is subject to tax. With a $14 million estate and a $14 million exemption, the tax is zero. The bypass trust saved a large amount of estate tax.
Bypass Trust Powers
The bypass trust is designed to use the exemption in the first estate and to avoid any tax in the second estate. In order to do this, the trustee must have limited powers to transfer assets to the surviving spouse. If the trustee, who may also be the surviving spouse, can simply transfer the property from the trust for his or her comfort or well-being, there is not an "ascertainable standard" and the trust will be included in his or her estate.
Therefore, the bypass trust typically has a requirement to pay income to the surviving spouse and permission to transfer principal to the surviving spouse under a "health, education, maintenance and support" standard. In essence, there is an "ascertainable standard" that governs the circumstances in which assets may be transferred to the surviving spouse.
It is also permissible to give the trustee a power to invade the trust to the extent of the greater of $5,000 or 5% of trust assets each year. This power is used fairly infrequently because the assets transferred from the bypass trust to the surviving spouse will be subject to estate tax when he or she passes away.
Bypass Trust Pitfalls
There are many benefits of a bypass trust, but there are also some cautions. First, if the family residence is transferred into the bypass trust, it will usually receive a stepped-up basis to the value when the first spouse passes away. If the home does not appreciate, the bypass trust could sell it without paying capital gains tax. However, if the house is held for a period of years and appreciates, the bypass trust does not qualify for the $250,000 capital gain exclusion for sale of a principal residence. Therefore, there could be substantial capital gains tax payable on that residence if sold by the bypass trust.
Second, if there is a blended family that is going to receive the bypass trust remainder, the spouse may attempt to use the "health, education, maintenance and support" standard to invade the trust. For example, if the surviving spouse is from a second marriage and the remainder of the bypass trust is going to children of the first marriage, he or she may attempt to invade the trust and then transfer it to his or her own children.
Finally, there could be conflict between the surviving spouse and a child. If the surviving spouse becomes ill and a child takes over as trustee, the child may be reluctant to provide high quality and expensive care for surviving spouse. This expensive care would deplete the trust and reduce the inheritance of the child. Therefore, this conflict of interest could cause problems.
Rights of the Surviving Spouse
In most cases, the surviving spouse will be trustee and will receive all income from the bypass trust. The surviving spouse will have the right to control the property. If there is a family residence in the trust, he or she will be able to live in the home.
Following the standards set up under the health, education, maintenance and support rule for invasion of principal, a surviving spouse may (with appropriate justification) invade principal. Finally, some trusts permit the surviving spouse the greater of $5,000 or 5% invasion power to take principal from the trust.
Bypass Formula Clause
The bypass trust normally is funded with a formula clause in the estate of the first person to pass away. Within that estate, there will be a fractional share or fixed dollar clause that is designed to allocate the maximum amount to the trust that will avoid federal estate tax. If the exemption equivalent is $12.92 million, that amount is generally allocated to the bypass trust.
The spouses and their counsel should also consider the impact of potential state inheritance or estate taxes. For most states, there will be tax that may be levied even on the first estate. Because the state inheritance and estate tax rates are lower than the federal tax, it may still be appropriate to fully fund the bypass trust. However, counsel and the two spouses should review the state tax impact on their plan.
Retirement Funds to Bypass Trust
If the first spouse to pass away has a majority of his or her estate in taxable retirement funds, it may be necessary to use those assets to fund the bypass trust. It is quite easy to do so through a beneficiary designation for the IRA, 401K or other qualified plan. For a 401K or in a community property state, it is necessary to have a spousal consent to fund the trust. In most cases, counsel will require a spousal consent if a trust is to be funded with an IRA, 401K or other qualified retirement plan.
The potential disadvantage of funding the bypass trust with a taxable retirement plan is that it is a wasting asset. That is, as the qualified plan is paid out to the bypass trust, it is subject to income tax. The federal and state income tax may exceed 40% on the plan payouts.
For example, with a $2 million IRA paid to the bypass trust over ten years, there could be $800,000 in federal and state income tax. The $2 million IRA could be reduced to $1.2 million after tax.
Bypass Charitable Remainder Unitrust
If the estate is fairly substantial, it may be preferable to transfer the IRA, 401K or other qualified plan into a bypass charitable reminder unitrust (CRT).
The bypass CRT is usually a 5% payout unitrust. It may exist for the life of spouse and lives of children, or it may exist for the life of surviving spouse plus a term of up to 20 years for children.
Because the bypass CRT qualifies for the use of the estate exemption and there is a charitable estate deduction for the value of the remainder interest, it may be larger than the typical bypass trust. For example, with a $12.92 million exemption and a $3 million present value of the remainder interest, it may be possible to fund the bypass CRT with $15 million and still have zero estate tax.
The CRT has the benefit of tax-exempt status. It may receive the full distribution from an IRA, 401K or other qualified plan tax free. The full value of the plan may then be invested for the benefit of the surviving spouse and children. The value of the total income distributed over a long period of time may actually be similar to the value of income plus principal in a regular bypass trust. With a regular bypass trust, the IRA or 401K will be depleted by payment of a high income tax rate.
$3 Million IRA to Bypass Trust or to Bypass CRT?
Mary has a $20 million estate. She passes away and transfers her $5 million IRA and other assets into her $12.92 million bypass trust for the benefit of her husband Joe and their son. The IRA is paid out over ten years. There is $1.2 million in income tax paid on the $5 million IRA, leaving $11.72 million in the bypass trust. Joe and the children receive income from $11.72 million for their lifetimes.
Martha also has a $20 million estate. When she dies, she transfers her $5 million IRA and other assets into a $15 million bypass charitable remainder trust. The trust receives a $5 million IRA distribution, but it is tax-exempt. All $15 million is invested to earn income for family for the duration of the lives of surviving spouse Mitchell and their children. This trust will eventually be transferred to charity, but the increased life income to family may offset the future gift to charity.