Portability Versus Bypass Trust: Practical Planning Tips
Portability Versus Bypass Trust: Practical Planning Tips
Portability has been heard all over the estate planning lecture circuit. But once the basic rules are understood, and the issues about the 2013 uncertainties rehashed, the bottom line for estate planning practitioners is what practical actions and options exist?
To Fund or Not To Fund - A Bypass Trust
The decision as to whether to fund a bypass trust, with the complexities just described, will have to be made without the benefit of hindsight. Thus, the determination as to whether to fund a bypass trust might consider a myriad of factors, including but not limited to:
• Which assets might be available to fund the bypass trust and how difficult might they be to transfer into the bypass trust.
• Are there assets that are not possible to transfer to the bypass trust but which might be protected by portability (e.g, professional practice or IRA).
• What is the anticipated appreciation potential of the assets involved.
• Anticipated inflation increase in the surviving spouse's exemption.
• Life expectancy of the surviving spouse (after the death of the first spouse).
• Anticipated state of domicile on the first and surviving spouse's death. If the first spouse dies this year in a decoupled state, incurring a state level estate tax now has to be weighed against relying on the uncertainty of portability after 2013.
• Likelihood of the surviving spouse remarrying a new spouse who dies before the surviving spouse (obviously impossible to gauge but the issues and opportunities should be noted in the discussions with the clients making the bypass versus portability decision).
Many more considerations will have to be evaluated to make the optimal decision. But in many instances, instead of going through this analysis, the use of appropriate trusts on the death of the first spouse will probably prove the safer bet and well worth the cost involved. Similarly, non-married partners will likely find trusts the way to go.
While a theoretical case can be made for circumstances when intentionally not funding a bypass trust is preferable, the only way to quantify that analysis would be to model the possible outcomes of the decisions. This would include forecasting future income and estate tax rates, growth in assets, state income and estate tax consequences, and other imponderables. The torrent of recent and often irrational and unexpected tax laws have proven that projecting future tax consequences is not art or science but more an exercise in futility. The safer and more conservative answer in most instances, considering the myriad of nontax benefits of using a trust, is to fund a trust on the first spouse's death. The reality will unfortunately be that most taxpayers with estates well under the $5 or $10 million thresholds will be reluctant to incur the incremental cost of planning for this, and the operational cost of maintaining a trust after the first spouse dies. That will prove for many a costly mistake. If clients won't fund the cost of a proper analysis, practitioners handling estates opting for one approach over the other should formally go on record with the executor as to the decision made and the issues it may create.
Non-Reciprocal Inter-Vivos Bypass Trusts
Some practitioners are recommending that taxpayers fund reciprocal bypass trusts using much of their available $5 million gift exemption amount. The rationale for this type of planning is that the growth in the assets so transferred will be outside their estates. If the exemption amount is reduced in 2013 or later years, the leverage of growth on the $5 million will continue outside the estate. If a bypass type structure is utilized then each spouse and the descendants or other agreed beneficiaries can all be benefited. If this type of planning is pursued, caution must be given to the risks posed by the reciprocal trust doctrine. The IRS might challenge such an arrangement as if the husband established a trust for the wife, while the wife established an identical trust for the husband, and then "un-cross" the reciprocal trusts causing inclusion in the respective estates. See U.S. v. Grace, 395 316 (1969); PLR 9643013; PLR 200426008.
If this type of planning is pursued, it is important to incorporate differences into each of the trusts to lessen the risk of this type of challenge. Several, not just one, differences should be created. The more significant the differences, the better to avoid the reciprocal trust doctrine. The trusts should be drafted pursuant to different plans. Separate memorandum or portions of a memorandum dealing with each trust separately may support this. The husband and wife should not be in the same economic position following the establishment of the two trusts (e.g. husband is a beneficiary of wife's trust, and wife is a beneficiary of husband's trust). The trusts should not be completely interrelated. Consider giving one spouse a "5 and 5" invasion power under one trust, but don't include a comparable (or any) "5 and 5" power under the second trust (this may be viewed as an immaterial difference according to some commentators). Include an inter-vivos special power of appointment (SPA) under one trust but not another. Endeavor to make this a meaningful power (e.g., more than just reallocating assets between the same group of children or grandchildren). Include a testamentary special power of appointment (SPA) under one trust but not another. Include a marital savings clause in one trust but not the other. Each trust should have different vesting options. For example, one trust could mandate distributions at specified ages and the other trust could use meaningfully different ages, or if state law permits, the second trust could be a perpetual dynasty trust. Use different distribution standards in each trust. For example, one trust could distribute solely based on an ascertainable standard, and the other trust could use a broader comfort and welfare or totally discretionary standard with an independent trustee. Add different beneficiaries to one of the trusts, but not the other. Note that if the husband creates a trust for the wife and their first child, and the wife creates a trust for the husband and their second child, this could still be unraveled under a reciprocal gift analysis. See Sather, 251 F.3d 1168 (8th Cir. 2001); See Schuler, 282 F.3d 575 (8th Cir. 2002). Another way to distinguish the trusts is to use different trustees for each trust. If neither spouse is a trustee or co-trustee and you have different trustees for each trust this could be a very significant factor. Use different time periods for each trust if feasible. Have the trusts signed at different times and have each trust hold different assets.
The Portability Bypass Combo
Estate planners will find in many planning scenarios that the use of both bypass and portability concepts can mesh quite well in a single estate. The following example illustrates.
Example: Decedent died in 2011 survived by Spouse. Decedent's estate consists of an IRA worth $1.5 million, a ½ interest in a house owned as tenants in common worth $600,000 and a brokerage account worth $2 million. Decedent's will provides for an outright marital bequest to the surviving Spouse and if a disclaimer is exercised the assets will pass to a bypass trust. Spouse reviews the situation and believes that there is some risk that the estate tax exclusion amount will decline in 2013, and that even at a $5 million level an estate tax might be due as a result of inflation. Spouse disclaims the interest in the house and brokerage account, but not the IRA, which is simply rolled over. So the bypass trust is funded, via disclaimer, with $2.6 million in assets. An estate tax return electing portability is filed. On the later death of Spouse, the $2.6 million plus all appreciation on it is excluded from her estate. Her applicable exclusion amount will consist of her own $5 million Basic Exclusion Amount (inflation indexed) plus her last deceased spouse's unused exclusion amount of $2.4 million [$5 million in 2011 reduced by the $2.6 million used on the funding of Decedent's bypass trust], or $7.6 million (ignoring inflation indexing of Spouse's exclusion).
Step Up In Basis with Portability and Not a Bypass Trust
One of the significant issues to evaluate in determining whether funding a bypass trust or relying on portability is preferable (leaving aside the uncertainty and other potentially deal breaker issues governing portability) is how to evaluate the trade off of using a bypass trust and preserving the unified credit amount, versus the opportunity for a step up in the income tax basis of those assets if they were instead included in the surviving spouse's estate and he/she, as surviving spouse, relied on portability. The difficulty of this decision is considerable.
• If capital gains tax rates rise, which many believe is inevitable, especially for higher income taxpayers, the trade-off of preserving the exemption versus garnering the basis step up may favor sacrificing a possible estate tax benefit for an income tax savings.
• If the client resides in a state with a state estate tax, the state estate tax when combined with a 35% federal estate tax might clearly weigh in favor of choosing to secure the estate tax benefit with a bypass trust rather than the increased exemption.
• A client who resides in a state with a state estate tax but which is unlikely to trigger a federal estate tax, might have to weigh the state estate tax against the combined federal and state capital gains tax increase that might be realized in the future by sacrificing the greater basis step up which portability might provide.
• If the client resides in a state with a state estate tax the potential for the client to relocate to a state without an estate tax prior to death may be another factor to consider.
Is a Disclaimer Bypass Trust the Optimally Flexible Planning Approach
Some practitioners are recommending the use of a disclaimer bypass trust for clients whose net worth appears to be under the federal exemption amounts (non-married $5 million and married $10 million). This approach does in fact provide more flexibility in that the taxpayers can defer any decision until the death of the first spouse at which time there may be more certainty. The reality according to large numbers of practitioners is that while a disclaimer bypass is the ultimate in flexibility, too often surviving spouses are reluctant to act upon it. This caveat should be made known to clients choosing to rely on this approach. Perhaps a letter of instruction from the clients to the survivor of them reminding the survivor of the reasoning behind the disclaimer may encourage better planning should that decision have to be addressed in the future.
While considerable uncertainty remains, and flexible planning options remain the best choice, many client scenarios will favor disclaimer bypass planning or inter-vivos bypass type trusts to use the exemption amount now, and post-mortem planning will include a mix of both bypass and portability options especially if the portability concept is made permanent.