There are at least five alternatives for married couples, which can provide flexibility to determine the appropriate funding for a bypass trust at the death of the first spouse. Some are appropriate for California spouses, others not:

1. Disclaimer trust. The entire estate of the first spouse is left to the surviving spouse with a provision allowing establishment of a bypass trust for any amount the surviving spouse disclaims.

The surviving spouse may be a beneficiary of the bypass trust which receives the disclaimed property, but may not  hold any power to direct who ultimately receives the property.

2. Zero-tax formula with disclaimer.  The bypass trust is allocated the lesser of the maximum amount that can pass free of the federal estate tax, or the maximum amount that can pass free of state death tax. As noted earlier, this approach is not likely to be used in California. Under such a provision, the surviving spouse can disclaim an interest in the remainder of the trust sufficient to increase the amount allocated to the bypass trust, which will have the effect of increasing state taxes on the estate of the

2. deceased spouse but lowering federal estate taxes at the surviving spouse’s death.

3. Single fund marital trust.  The entire estate of the first spouse to die is left in trust for the benefit of the surviving spouse. He or she must be entitled to receive all trust income, but may not possess any power of appointment over the trust.

If these requirements are satisfied the executor may elect to treat only part of the trust as qualified terminable interest property (QTIP), which will qualify for the marital deduction. The part not elected for QTIP treatment may exhaust the deceased spouse’s federal estate tax exemption. Here, the executor rather than the surviving spouse, is the person who determines how much property will be qualified for the marital deduction and how much will be used to satisfy the federal (and any state) exemptions available in the estate of the deceased spouse.

4. Clayton QTIP trust.  Similar to a single fund marital trust, the “Clayton” QTIP trust gives the executor the power to determine how much property will qualify for the marital deduction by making a partial QTIP election. However, unlike the

4. single fund marital trust option, the property is not retained in one trust.

If the surviving spouse disclaims his or her interest in the nonmarital trust, the nonmarital portion may either be held in a separate trust, be distributed outright to the deceased spouse’s descendants, or allocated to a bypass trust for the descendants’ benefit .

5. Three trust approach. While other approaches divide the deceased spouse’s estate into two shares (the bypass share and the marital deduction share), the three trust approach divides the estate of the first spouse into three shares. The first equals the amount exempt from both federal and any state death taxes. The second equals the amount by which the federal estate tax exemption exceeds the state exemption—assuming the state exemption is lower than the federal exemption. The second share should be held in a trust that qualifies for the QTIP election under state law. The third consists of the remainder of the estate, which may be held in trust or distributed outright to the surviving spouse—this is the traditional “marital” share. [See Pg 3]

 

Tax Planning [From Pg. 1]

Page 2

Briefly Speaking

 

“ . . . a fully funded bypass trust may no longer be advantageous.”

 

When  bypass trusts make sense

For married couples with a net worth substantially in excess of the federal estate tax exemption, a traditional bypass trust funded with the maximum amount may still be appropriate. This holds true even when the state in which they live has pulled out of the federal estate tax system.

In such cases it may be more effective to pay some state estate or inheritance tax at the death of the first spouse to die to maximize the federal estate tax exemption. Why? Property unnecessarily included in the surviving spouse’s estate will likely be taxed (at what will probably be a higher federal tax rate) on the death of the surviving spouse.