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Living With a Bypass Trust
Lisa
Nachmias Davis
Davis O'Sullivan & Priest LLC
59 Elm Street, Suite 540
New Haven, CT 06510
Phone: 203-776-4400 / Fax 203-774-1060
(last updated
5/20/22)
TECHNICALLY, a trust is an
arrangement between a grantor or settlor, who sets it up, and a
Trustee, who runs it, to manage and distribute property, a "res" for
the benefit of others, the "beneficiaries." That's what we learn
in law school.
There are as many kinds of trusts as animals
in the zoo. Maybe not quite so many, but too many to describe one by
one! (See other articles published on this site.) This
article describes a "Bypass Trust," part of a couple's
estate plan designed to prevent assets owned by the first spouse to die
from passing directly to the second spouse and being exposed to tax in
the second spouse's estate. See my explanation, "Do you need a Bypass?"
In my Bypass article, I explained that if
Ozzie and Harriet had $8 million between them, Ozzie's estate plan
might leave "his" $4 million to a "Bypass Trust" for Harriet and the
kids, rather than to Harriet, so that on her death she'd only have $4
million which would escape estate tax if they died in 2026 -- saving
the heirs
over $1 million. Any estate plan for Ozzie including a Bypass
Trust
would have these features: (1) Harriet would be a beneficiary
(not necessarily the only one); (2) Harriet could not hire and fire the
Trustee unless the new Trustee would be someone "independent" from her;
(3) if Harriet were herself the Trustee, her ability to take money out
would be limited to "health, education and support" or "health,
support, maintenance in reasonable comfort, education" or similar words
(NOT loose words like "welfare"); (4) any ability the trust might give
her to re-direct where the property would go at her death would exclude
herself, her creditors, her estate, and the creditors of her estate;
and (5) any right the document might give her to "withdraw" money for
no reason, would be limited to the greater of $5,000 or 5% of the trust
property.
You'll notice that this is a list of
"nots." If any of these "no-nos" are violated, the trust could
still wind up being taxed on Harriet's death, treated as her alter
ego. Some lawyers are so nervous about violating any of these
no-nos that the Bypass trust document will require an Independent
Trustee, will prevent Harriet ever firing the trustee, or will limit
her to getting only income, or only money for "support." Some
lawyers may want to restrict Harriet's access so she won't "waste" the
trust, which is protected from estate tax, rather than using her own
property (which will be taxed when she dies). And if it is a
second marriage, or Ozzie wants to keep a little more control over what
happens after he's gone, the trust might simply say that on Harriet's
death what is left goes to the kids, period.
When I draft a Bypass Trust, subject to
my clients' particular wishes, my starting assumption is that they want
me to make it as painless as possible -- make Harriet feel that it is
as close as I can possibly get to having her own the property herself,
outright, without resulting in the property being taxed when she
dies. Subject to the "no-no" list, my documents will allow
Harriet to fire the Trustee, will allow Harriet to adjust for changing
circumstances by somewhat re-arranging what happens to the money when
she dies (known as a "power of appointment"), allow her to take out 5%
per year for any reason, although only at the end of the year -- I'll
explain that if you ask me -- and allow Harriet to be her own Trustee,
although if she wants money for something other than "heath, education
and support" she has to get an Independent Trustee as co-Trustee to
make the decision. That's where I start, but I make changes to
fit each client's circumstances.
As with any trust, the Trustee of a
Bypass Trust is supposed to act with reasonable care and prudence,
investing sensibly, balancing the interests of the beneficiaries; may
be required to account for what is done with the trust property (show
the books, do a financial statement); must file tax returns; may be
hauled into probate court and fired by the judge if accused of stealing
or neglect. As with any trust, the trust assets are managed for
the benefit of certain beneficiaries (Harriet) and on the life
beneficiary's death, pass to remainder beneficiaries.
Suppose Ozzie dies, and Harriet finds
herself the beneficiary of the Ozzie Bypass Trust. She is the
Trustee. As Trustee, with the help of the lawyer or accountant,
she will get a separate tax identification number for the trust -- like
a Social Security number. She'll have to go to the bank or
brokerage , and arrange for everything Ozzie had that passed to the
trust when his estate was settled to be re-titled in the name of the
trust. The interest and dividends that the trust earns will be reported
to the IRS as being income of the trust. This means that the trust must
file its own tax return every year, IRS Form 1041, and pay its own tax,
EXCEPT that if it distributes out interest and dividends, it gets a tax
deduction for this and the amount passed out is reported by Harriet (or
whoever got the money).
As Trustee, Harriet pays herself the income;
as beneficiary she receives it. In other words, as Trustee she writes a
check on the Trust's bank account or CMA account at the brokerage, and
deposits it in her own bank account. She talks to the accountant
to figure out just what has to come out of the Trust account each year
to keep the Trust's income taxes low. In addition, as Trustee, she can
pay more to herself as beneficiary, provided it is for things like
property taxes, or food, or utilities, or health insurance premiums or
copays and deductibles, or dentist bills, or taking a course at the
local college. If she wants to take trust money to go on a
cruise, set up a charitable foundation, go to the casino, she'd have to
resign as Trustee, or add a co-Trustee who could decide if that was a
prudent and appropriate thing for the trust to do. In
Connecticut, she does not have to file reports with the children -- the
remainder beneficiaries -- but if the children think she is abusing her
Trustee position, they do have the legal right to demand information,
take her to court, or ask the judge to remove her. If I wrote the
trust, she'd also be able to make gifts to the children out of the
trust funds, by "appointing" property to them during her lifetime, or
making distributions to them for their needs. It also depends on
the relationship with the children AND with whose children they are --
both Ozzie and Harriet? or only Ozzie?
What if Harriet isn't the trustee any
more? In that case, she would talk to the Trustee about her needs and
the Trustee would arrange to pay them. She'd have to persuade the
Trustee she really needed money from the trust (unless it mandates that
she get the income), since the Trustee would have to worry about the
children suing him or her if the trust assets were depleted by the time
of her death. The Trustee would make distributions in the
Trustee's "discretion." If I prepared the Trust, she'd at least
have the ability to name new Trustees if the Trustee resigns, and/or to
fire the Trustee. (Only if she BOTH fires the Trustee AND puts in
a new one, would she have to pick someone truly independent.)
So -- DEPENDING ON HOW THE TRUST IS
WRITTEN -- being the beneficiary of a Bypass Trust may involve extra
complications, paperwork, and tax returns, but remain relatively
painless -- while saving the kids six figures in state taxes. Not
bad! The devil is in the details: what does the trust
document actually say? Remember to read the document closely and
to ask your lawyer questions about the limits and requirements.
WARNING -- these trusts do NOT help anyone qualify
for Medicaid to avoid paying for long-term care expenses. I assume that
if you have more than $2 million, you can afford to pay some of this
for long-term care and/or purchase long-term care insurance -- but you
should know that if you are already beneficiary of a Bypass Trust, even
though the IRS won't consider this part of your "estate," the
Connecticut Department of Social Services will - - the whole amount
will in most cases have to be consumed before you, the beneficiary, can
qualify for Title 19.
WARNING #2 -- the trust needs monitoring to see if it's really needed,
because when asset in the trust are sold there won't be the "step-up"
in basis (ask Google on that one) and there may be a lot of capital
gains tax to be paid-- potentially 40%. Sometimes it makes sense
to distribute assets out to Harriet or even get rid of the trust
entirely to avoid capital gains tax later. Conversely, if it was
Ozzie's second marriage and he really wanted his kids to inherit when
Harriet died, (a) he might want to restrict the payouts and (b) he
might even decide Harriet shouldn't be trustee on her own.
CAUTION:
EVERYTHING I JUST WROTE HAS EXCEPTIONS AND FINE POINTS AND MAY CHANGE
AT THE WHIM OF CONGRESS, THE STATE LEGISLATURE, ETC. THIS IS A
VERY GENERALIZED EXPLANATION. IT IS ABSOLUTELY ESSENTIAL THAT YOU MEET
WITH YOUR OWN ATTORNEY AND PROVIDE YOUR ATTORNEY WITH FULL INFORMATION
ABOUT WHAT YOU OWN AND THE WAY IT IS TITLED -- AND THAT YOU FOLLOW YOUR
ATTORNEY'S INSTRUCTIONS!
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