How a Bypass Trust can help to reduce your estate taxes . . .

A Bypass Trust is helpful in reducing estate taxes because it allows both spouses to take full advantage of the unified tax credit. Here's how it works.

The federal gift and estate tax system can be thought of a giant tax net which surrounds us and which imposes a tax whenever assets leave our estate as a gift or a bequest. The gift tax applies to transfers during our lifetimes, and the estate tax applies to transfers after our death. The estate and gift taxes can be expensive. The maximum tax rate is 46%!

There are some exceptions to these taxes.

The first exception, called the marital deduction, applies to transfers from one spouse to the other spouse. The marital deduction is unlimited, so there is never a tax on transfers between spouses.

The second exception, called the unified tax credit, gives each of us a credit which essentially acts as a deductible. The amount of those credits has been gradually increasing over the last few years. In 2009, the unified tax credit will shield transfers up to $1,000,000 per person for lifetime gifts and up to $3,500,000 per person for transfers after death -- that's $7,000,000 between the husband and the wife. In 2010 the gift and estate taxes are repealed, so there will be no tax on transfers in 2010.

There's also an annual gift tax deduction. In 2009 it is $13,000 per person per donee. Using this annual deduction is another important tax reduction strategy . . . but that's a story for another day.

So why should we worry? Most of us would dearly love to have an estate large enough to be taxed under the gift and estate taxes in 2009. Here's the rub . . . In 2011 the gift and estate taxes are reinstated, and the unified tax credit is reduced to shield only $1,000,000 per person. More importantly, what Congress gives, it can take away. In the present economy the federal government is shelling out well over a trillion dollars in bailout money, and somebody's going to have to pay for it eventually. Gift and estate taxes are a very likely target for raising future tax revenues. If you're planning to continue living until 2011 or later, it's important that you do tax and estate planning now to protect you and your family in the future.

If everything is left to the surviving spouse, there's no tax when the first spouse dies . . . but when the second spouse dies, the tax could be a whopper!

The common tendency when married couples plan their estates is to leave everything to their spouse if the spouse survives, and if the spouse does not, in equal shares to their children who survive. In the real world, that makes sense. In the tax world, it could be expensive.

The problem with the usual scenario is that on the death of the second spouse, all of the marital estate is now in the surviving spouse's estate, and it's twice as likely to exceed the estate tax shield.

Here's where the Bypass Trust comes in.

The strategy of the Bypass Trust is to split the Trust Estate into two parts when the first spouse dies -- the Survivor's Trust and the Bypass Trust. One part - the Bypass part - is computed to be in an amount which will take full advantage of the unified tax credit attributable to the estate of the deceased spouse. The rest of the Trust Estate is allocated to the Survivor's Trust. Even if the amount in the Survivor's Trust is greater than the amount shielded by the tax credit, there is no tax at that time because of the marital deduction. Then when the surviving spouse dies, the amount in the survivor's estate has been reduced by what went to the Bypass Trust.

It's not as though the surviving spouse is deprived of the benefit of the Bypass Trust because it is set up so that all of the income from that trust goes to the survivor. In fact, if needed for the support or maintenance of the surviving spouse, the principal of that trust can also be distributed to help the survivor.

In short, this strategy allows the married couple to take full advantage of the unified tax credit for each spouse. If everything is simply distributed to the survivor, then the unified tax credit for the deceased spouse is wasted.

Our firm would be pleased to discuss the whole topic of trusts and estate planning with you. For a 1/2 hour no charge consultation with Dave Guinan, click here.

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