Upstate Estate Law, P.C. Blog

A BYPASS TRUST (also called a credit shelter trust, the “B” trust of the “AB” trust arrangement, or the family trust) is a type of trust typically set up by a married couple that is concerned about estate tax liability.

The bypass trust is set up to receive that amount of assets that equals the amount of the federal estate tax exemption in effect when the first spouse dies.  It is called a bypass trust because the assets contained in the trust escape estate taxation when the surviving spouse passes away, in effect, ‘bypassing’ estate taxation in the surviving spouse’s estate.

The beneficiary of the bypass trust is usually the surviving spouse, but this is actually not required. Children of the first spouse to die are often included as beneficiaries as well.

The requirements of the bypass trust are rather simple. It is usually funded by a provision in a Last Will or Revocable Living Trust which in effect states that it is to be funded up to the amount of the federal estate tax exemption amount (there are numerous ways that this funding provision can be drafted, but it is usually easily recognized once you see it).

Other requirements are that the surviving spouse is typically entitled to all the income from the bypass trust, plus a portion of the principal of the trust each year equal to the greater of $5,000.00 or 5% of the principal.  The surviving spouse may have some power to appoint the bypass trust assets upon death to certain beneficiaries that he or she names, this is called a limited power of appointment. (*A limited power of appointment cannot be included in the event that it is expected that the bypass trust will be funded as a result of a qualified disclaimer by the surviving spouse.)

The surviving spouse may be the sole trustee of the bypass trust, but this requires some restrictive language if the bypass trust allows for the making of discretionary principal distributions from the trust. The language allowing distributions must state that distributions from the trust may only be made for the health, education, maintenance, and support of the surviving spouse. If there is a co-trustee serving with the surviving spouse, the co-trustee can be given broad discretion to make distributions for the welfare of the surviving spouse. It is typically beneficial to have a co-trustee serve alongside the surviving spouse.

The bypass trust offers a method by which spouses whose estates will be valued near the federal estate tax exclusion amount can be sure to take full advantage of each of their estate tax exclusions. It should not be attempted without professional help, it takes more than just signing the trust document to make it work, the ownership of assets will most likely need to be rearranged as well.

I will revisit the bypass trust once I make my way to P, when I will discuss the new estate tax concept of Portability.

Like any decent lawyer, I need to add a disclaimer here: unfortunately, it is impossible to offer comprehensive legal advice over the internet, no matter how well researched or written. And remember, reviewing this website and my blogs doesn’t make you a client of my Firm: before relying on any information given on this site, please contact a legal professional to discuss your particular situation. 

Attorneys can be a strange lot.  They make up terms that nobody understands seemingly for no reason.  One such term is the intentionally defective grantor trust.  What is a grantor trust? Why would it ever be defective? And why would this be done intentionally?  Good questions all.

First, what is a grantor?  Well, a grantor is the person that sets up the trust and transfers his/her assets to it.

Second, what is a grantor trust? A grantor trust is a trust that is deemed to be owned by the grantor. This is important because it is the owner who is responsible for paying and filing the income taxes.  When the trust is a grantor trust, then it is the grantor that owns the income from the trust, and gets the benefit of the deductible expenses of the trust.  This allows the trust income tax brackets to be avoided in favor of the more favorable individual income tax brackets.  A grantor trust does not have to apply for a new taxpayer identification number because the grantor’s social security number is used.

How do you know whather a trust is a grantor trust? You determine this by reference to the trust instrument itself. What does the trust say? What powers does it grant? How is it structured? When you know this, you then take a look at the Internal Revenue Code, Sections 672 through 678. These sections are commonly known as the Grantor Trust rules.  As an example, a trust that is revocable by the Grantor is a grantor trust, and we know this by reference to IRC Section 676.  A trust that allows the Grantor to amend it to add beneficiaries (other than after adopted or born children) is a grantor trust and we know this by reference to IRC Section 674.  There are many other powers that can be granted in the trust to cause the trust to be a grantor trust.

Now that we know what a grantor trust is, why would we ever set up an intentionally defective grantor trust? An intentionally defective grantor trust is a trust that intentionally contains a provision that causes the trust to be a grantor trust.  This is done in the situation where it is desirable to structure a trust in a way that allows the trust assets to not be includible in the grantor’s estate, but still taxable for income tax purposes to the grantor.

The Irrevocable Life Insurance Trust (ILIT) is an example of Click here to finish this post.

In McDaniel v. Kendrick, Op. No. 4643 (S.C. Ct. App. filed December 31, 2009), the South Carolina Court of Appeals decided a real estate dispute with a tangential relationship to estate planning. Oftentimes, a mom or dad will decide as part of their estate planning to transfer a home to a child as a gift, with the expectation that the parent would continue to reside in the home for the rest otheir lives. This might be done for medicaid qualification purposes (assuming medicaid is not expected to be necessary for at least five years), or estate tax purposes. What happens however is the relationship between parent and child or parent and spouse of child deteriorates, and the parent is evicted from the home.

There is an equitable legal doctrine known as a constructive trust that could come to the parent’s rescue in the above situation. While the McDaniel case did not concern a home transfer for the purpose of estate planning, it involved Click here to finish this post.

The terms above refer to two major categories of trusts.  An inter vivos trust is a trust that was created during the lifetime of the Trust Grantor/Settlor.   A testamentary trust is set up upon the death of the Trust Grantor/Settlor, typically in a Last Will. 

Some distinctions are that an inter vivos trust may be freely revocable by the Grantor/Settlor, whereas the testamentary trust is irrevocable.  The inter vivos trust may be set up to accomplish asset management, incapacity planning, or Medicaid planning for the Settlor/Grantor.  A testamentary trust is useful to protect the Settlor/Grantor’s eventual beneficiaries from dissipating their inheritance through immaturity, creditors’ claims, divorce, and the like. 

South Carolina is one of about 38 states plus the District of Columbia that allow for trusts to be established for the benefit of animals and pets.  While such trusts had not been recognized under the state common law because there were no human beneficiaries to enforce their terms, the South Carolina Trust Code now makes such trusts valid. Click here to finish this post.