Estate Planning for Spouses with Marital Deduction/Bypass Trusts after the Tax Cuts and Jobs Act

By: David W. Wulfers

The Tax Cuts and Jobs Act became law in December 2017, changing the landscape of estate planning for a limited time. The estate, gift and generation skipping transfer tax exemptions each increased to $10,000,000, adjusted for inflation, for each individual.^[1] However, those changes will sunset on December 31, 2025, and the exemption amount will return to $5,000,000 (adjusted for inflation) for each individual, unless the Congress does something to change the sunset provision.

The following table describes the applicable periods, exemption amounts and rates:

If you and your spouse currently have an estate plan which includes a revocable marital deduction/bypass trust plan, there are certain things to consider as a result of the Act.

I. Design of the marital deduction/bypass trust

For a married couple, the marital deduction/bypass trust, sometimes referred to as an AB trust, can take the form of a revocable living trust created by each spouse as grantor, or a joint revocable trust created by both spouses as grantors. On the death of the first spouse, the trust usually is divided into two trusts, one identified as a “bypass trust” or “Trust B,” and the other identified as a “marital deduction trust” or “Trust A.” The purpose of the division is to preserve the federal estate tax exemption of the first spouse to pass away, i.e. the federal estate tax exemption amount of the first spouse is utilized to fund the bypass trust, and thus federal estate tax on those assets is avoided. The balance of the assets also avoids federal estate tax, because the unlimited federal marital deduction allows those assets to pass to the marital deduction trust, estate tax free.

Usually, the primary beneficiary of the bypass trust is the surviving spouse, with the income generated by the assets in the bypass trust paid to the surviving spouse. The principal in the bypass trust used for expenses of the surviving spouse, such as health and support, but not generally accessible to the surviving spouse. In return for the limits placed on what the principal in the bypass trust may be used for, those assets will not be included in the surviving spouse’s estate for federal estate tax purposes at his or her death, and are passed to the contingent beneficiaries of the bypass trust free of federal estate tax.

The surviving spouse is the beneficiary of the marital deduction trust. The assets which fund the marital deduction trust may be used by the surviving spouse for any purpose. On the death of the surviving spouse, the assets typically pass to the bypass trust and then to the beneficiaries of the bypass trust federal estate tax free, by utilizing the federal estate tax exemption of the surviving spouse.

II. Downside of the marital deduction/bypass trust structure

The following are a few of the potential issues using the marital deduction/bypass trust structure in today’s environment.

1. Increases in the federal exemption amounts under the Act

Generally, a formula is used to determine the amount which funds the bypass trust. The calculation begins with the deceased spouse’s federal estate tax exemption amount. In the late 1990′s, the federal estate tax exemption amount for an individual was $600,000. If a married couple’s assets held by their marital deduction/bypass trust exceeded that amount, the marital deduction/bypass trust estate plan structure made sense. For example, if the assets owned by the trust were valued at $1,000,000 on the death of the first spouse, the bypass trust could possibly be funded up to the $600,000 amount, and the balance, $400,000, funding the marital deduction trust.

The Economic Growth and Tax Relief Reconciliation Act of 2001 began a gradual increase in the individual federal estate tax exemption amount. The Tax Cuts and Jobs Act of 2017 has added fuel to the fire. In its simplest terms, under the formula the higher the individual federal estate tax exemption amount, the less likely there will be funding of the marital deduction trust, or possibly no funding of that trust.

For example, if a marital deduction/bypass trust includes the above formula, and in 2020 the trust owned assets valued at $5,000,000 and the first spouse passed away in 2020, the formula would direct the entire $5,000,000 be used to fund the bypass trust, and no assets would be left to fund the marital deduction trust. That is because each individual’s federal estate tax exemption amount in 2020 is $11.58 million. If it is important that the surviving spouse have unrestricted access to assets, then the marital deduction/bypass trust structure may not be appropriate now.

2. Use of the income tax basis of assets

Currently, except for assets producing income that the deceased was entitled to, but hadn’t yet received, at the time of his or her death (such as retirement accounts and installments notes), the income tax basis of an asset held by an individual will be “stepped up” to the fair market value of that asset on the individual’s death and received by the beneficiary or heir at that fair market value. For example, if an individual bought a house in 1980 for $50,000 and passed away in 2018, with the house then appraised at $150,000, the beneficiary or heir would receive the house at its then fair market value, $150,000, i.e. receive a “stepped up” income tax basis in the house at that amount. If the beneficiary or heir sold the house in 2019 for $160,000, the beneficiary or heir would only pay income tax on the $10,000 difference between the sales price and the fair market value of the house.

In the context of the marital deduction/bypass trust, on the death of the second spouse, the assets in the bypass trust do not receive a “stepped up” income tax basis to their then current fair market value, but pass to the contingent beneficiaries of the bypass trust without the “stepped up” income tax basis. The assets in the marital deduction trust do receive a “stepped up” income tax basis.

If the married couple has contributed assets to the trust which have substantially increased in value over the years, and use of the individual federal estate tax exemption amount to avoid federal estate tax is not an issue, then the couple may wish to consider amending the trust. The amendment could eliminate the marital deduction/bypass trust structure. That would allow the “stepped up” income tax basis to be applied on the death of the first spouse and on the death of the surviving spouse.

The Conclusion

Amending a marital deduction/bypass trust is one method of addressing some of the issues described above. There are a number of possible recommendations, which a client may discuss with his or her estate planning attorney.

Doerner, Saunders, Daniel & Anderson, LLP provides this content for informational purposes only. It is not intended to provide legal or other professional advice nor does the transmission of this information create an attorney-client relationship between any attorney of the Firm and the reader. If you seek legal advice or assistance, please consult with a competent attorney familiar with the applicable laws. If you wish to initiate possible representation by an attorney with this Firm, please call the attorney of your choice. You will be advised of our processes to avoid conflicts of interest and requirements of our letter of engagement before the commencement of representation.

^[1]This article only addresses individuals who are U.S. citizens.

^[2]The Act changed how the inflation adjustment is calculated. Under the Act the inflation adjustment is now based on the chained Consumer Price Index, rather than the prior traditional Consumer Price Index. The change should result in smaller annual increases in exemption amounts.