Bypass Trust

A bypass trust, often referred to as a credit shelter trust, is a sophisticated estate planning tool designed to minimize estate taxes upon an individual's death. 

This legal arrangement allows an individual to pass assets to their heirs while leveraging the available estate tax exemption. 

By placing assets into the trust, the grantor effectively "bypasses" their estate, thereby reducing the overall taxable value of their estate, ultimately preserving more wealth for beneficiaries.

A bypass trust is established by an individual (the grantor) during their lifetime or through their will. It is designed to shelter a portion of their assets from estate taxes. When the grantor passes away, the assets placed into the trust are not considered part of their taxable estate. Instead, they are managed by a trustee for the benefit of specific beneficiaries, typically the grantor's spouse and/or children.

One key feature of a bypass trust is that it takes advantage of the estate tax exemption amount. 

The estate tax exemption amount for 2023 is $12,920,000 per individual, meaning that $12,920,000 can be passed to beneficiaries without incurring estate taxes. The estate tax exemption amount for 2024 is $13,610,000 per individual. 

Any assets placed in the bypass trust up to this exemption limit would not be subject to estate tax upon the grantor's death. This strategy effectively "bypasses" taxation on these assets, preserving more wealth for future generations.

A bypass trust can also provide income to the surviving spouse while keeping the principal assets protected. Upon the surviving spouse's passing, the trust assets can pass to the designated beneficiaries, such as children or other heirs, without being subject to another round of estate taxes.

It’s important to note that the current legislation that allows a large estate tax exemption amount is set to “sunset” or expire after 2025. Beginning in 2026, then, the estate tax exemption amount will fall back to an estimated $6,400,00 per individual (exact figures have not yet been outlined by Congress).

What does the sunset of the estate tax exemption mean? Well, a lower estate tax exemption amount may mean that estate planners need to be more shrewd in crafting gifting strategies to avoid a hefty tax bill.

Let's consider a married couple, Sarah and Mark, who have a combined estate worth $25 million. They have two children and want to ensure that their estate passes to their children with minimal tax implications. To achieve this, they set up a bypass trust.

Suppose Sarah passes away first. According to the terms of the bypass trust, $12,920,000 of her estate is transferred into the trust. This amount is equal to the 2023 federal estate tax exemption. The remaining $12,080,000 would go directly to Mark, her surviving spouse.

Mark would receive income generated by the $12,920,000 in the bypass trust for the rest of his life. He could also access the principal amount for specific needs, such as medical expenses or educational costs for their children, depending on how the trust is structured.

When Mark eventually passes away, his estate would be worth $12,080,000, assuming no other changes. This amount is below the 2023 federal estate tax exemption of $12,920,000, so no federal estate taxes would be due on his estate.

Upon Mark's death, the $12,920,000 in the bypass trust would pass to their children, tax-free, because it was already exempted from estate tax upon Sarah's death. Mark's own $12,080,000 would also pass to their children tax-free, thanks to his own federal estate tax exemption.

By using a bypass trust and the 2023 federal estate tax exemption amount of $12,920,000, Sarah and Mark would successfully pass on their entire $25 million estate to their children without incurring any federal estate taxes.