The bypass trust, also known as the credit shelter trust, the family trust and the “B” trust, has been the foundation of estate planning for married couples since before I started practicing law. Prior to 2011, such a trust was necessary to ensure that the applicable exclusion amount of the first spouse to die wasn't wasted. Otherwise, if all of such spouse's assets were transferred to the surviving spouse in a manner that qualified for the marital estate tax deduction, they would be included in the surviving spouse's estate upon his death. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the 2010 Tax Act), however, introduced a new concept into the estate planning world: “portability” has replaced “use it or lose it.” Under the 2010 Tax Act, for decedents dying after 2010, a surviving spouse can utilize the unused applicable exclusion of his deceased spouse. Nevertheless, for the reasons discussed below, although portability is certainly a welcome and useful addition to the estate tax regime, the bypass trust should remain the foundation of most married couples' estate plans.

Portability Provisions

Section 303(a) of the 2010 Tax Act amends Section 2010(c)(2) of the Internal Revenue Code of 19861 by adding new paragraphs (c)(3), (4), (5) and (6) and makes certain conforming amendments to other IRC provisions (See “2010 Tax Act Amendments,” this page).

Deceased spousal unused exclusion amount

The 2010 Tax Act thus achieves portability by redefining the term “applicable exclusion amount” to equal the sum of (1) the “basic exclusion amount,” that is, $5 million (as indexed for inflation after 2011), and (2) in the case of a surviving spouse, the deceased spousal unused exclusion amount (DSUEA). The DSUEA is defined as the lesser of (1) the basic exclusion amount, or (2) the basic exclusion amount of the “last deceased spouse” less the amount with respect to which the tentative tax on the estate of such deceased spouse is determined. In other words, DSUEA equals the unused basic exclusion amount of the “last” deceased spouse of the surviving spouse.

Example 1: Husband dies in January 2011 and only uses $1 million of his $5 million basic exclusion amount. Wife dies in December 2011. Wife's applicable exclusion amount is equal to her own $5 million basic exclusion amount plus Husband's $4 million of DSUEA, for a total of $9 million.

It's important to note that whether the deceased spouse actually had assets equal to his unused exclusion amount is irrelevant.

Accumulation of unused exclusions not allowed

Portability only applies to the unused exclusion amount of the “last” deceased spouse of the surviving spouse. This rule forecloses the possibility of accumulating the unused exclusions from several marriages.

Example 2: Husband dies in January 2011 and only uses $1 million of his $5 million basic exclusion amount. Wife remarries in June 2011. Second Husband dies in July 2011, using $3 million of his $5 million basic exclusion amount. Wife dies in December 2011. Wife's applicable exclusion amount is equal to her own $5 million basic exclusion amount plus Second Husband's $2 million of unused basic exclusion amount, for a total of $7 million (not $5 million + $4 million + $2 million).

In the case of gifts, a person possibly could use the DSUEA from multiple spouses. But, the maximum amount of the applicable exclusion amount for a person will never be more than twice the basic exclusion amount.

Example 3: Husband dies in January 2011 and has used $3 million of his $5 million basic exclusion amount. Wife makes a gift of $7 million in June 2011. No gift tax is due because Wife's applicable exclusion amount is $7 million. Wife marries Second Husband in January 2012. Second Husband dies in October 2012 using none of his $5 million basic exclusion amount (assumes no inflation adjustment). Wife makes a gift of $5 million in December 2012.

  • Under Section 2505(a), Wife's credit amount is calculated based on an applicable exclusion amount of $10 million (Wife's own $5 million basic exclusion amount plus Second Husband's $5 million of DSUEA), reduced by the sum of the amounts allowable as a credit to the Wife under Section 2505 for all preceding calendar periods, which would be based on an applicable exclusion amount of $7 million.
  • Wife thus has $3 million of applicable exclusion amount available ($10 million minus $7 million), even though Second Husband has $5 million of DSUEA.

If amount of DSUEA is later reduced

The newly added Section 2010(c)(6) gives the Secretary of Treasury the authority to prescribe regulations as necessary or appropriate. One of the issues that the regulations hopefully will address is how a reduction in the DSUEA due to another marriage and death2 should be treated where prior to those events, the surviving spouse used or intended to use a larger amount of DSUEA. Presumably, in the case of a lifetime gift, no additional gift tax should be due because the credit against the gift tax was properly allowable at the time of the gift.

Example 4: Husband dies in January 2011 and only uses $1 million of his $5 million basic exclusion amount. Wife makes a $9 million gift in December 2011. Wife remarries in January 2012. Second Husband dies in July 2012, using $4 million of his $5 million basic exclusion amount (assumes no inflation adjustment). In December 2012, Wife makes a gift of $1 million.

  • Under Section 2505(a), Wife's credit amount is calculated based on an applicable exclusion amount of $6 million (Wife's own $5 million basic exclusion amount plus Second Husband's $1 million of DSUEA), reduced by the sum of the amounts allowable as a credit to the Wife under Section 2505 for all preceding calendar periods, which would be based on an applicable exclusion amount of $9 million.
  • Wife's credit amount thus is technically negative. Presumably, however, only the $1 million would be subject to gift tax.

The timing of a remarriage, however, could trigger a gift tax. Section 2505(a)(1) states “the applicable credit amount in effect under section 2010(c) which would apply if the donor died as of the end of the calendar year, reduced by … ” (emphasis added). Thus, if the DSUEA of a donor decreases after a gift has been made, but before the end of the calendar year in which the gift has been made, the donor could owe gift tax.

Example 5: Husband dies in January 2011 and only uses $1 million of his $5 million basic exclusion amount. Wife makes a $9 million gift in February 2011. Wife remarries in June 2011. Second Husband dies in December 2011, using all of his $5 million basic exclusion amount.

  • Under Section 2505(a), Wife's credit amount is calculated based on an applicable exclusion amount of $5 million (Wife's own $5 million basic exclusion amount).
  • At the time of the gift, Wife thought she had $9 million of applicable exclusion amount. However, in calculating such amount as if Wife had died at the end of 2011, she only has $5 million available for 2011 due to the change in DSUEA from the remarriage and second death. Thus, Wife would seem to owe gift tax.

Recapturing of gift tax

The reunification of the gift and estate tax appears to open the possibility of lifetime gifts that weren't subject to gift tax becoming subject to estate tax. In effect, the gift tax would be “recaptured” at death.

Example 6: Husband dies in January 2011 and only uses $1 million of his $5 million basic exclusion amount. Wife makes a $9 million gift in December 2011. Wife remarries in January 2012. Second Husband dies in July 2012, using $4 million of his $5 million basic exclusion amount (assumes no inflation adjustment). Wife dies in December 2012.

  • Wife's applicable exclusion amount is equal to her own $5 million basic exclusion amount plus Second Husband's $1 million of DSUEA, for a total of $6 million.
  • In calculating Wife's taxable estate, the $9 million in gifts will be taken into account. No gift tax will have been paid with respect to the $9 million in gifts.
  • However, Wife's applicable exclusion amount will only be $6 million. Thus, $3 million in gifts that weren't subject to gift tax would appear to be subject to estate tax.

Unless and until the Internal Revenue Service clarifies the above issue, practitioners should carefully consider the potential implications on a client's overall estate plan at death if gifts made during life are potentially subject to estate tax.3

Two Special Rules

IRC Section 2010(c)(5) sets forth two special rules applicable to the portability provisions. First, Section 2010(c)(5)(A) provides that the executor of the estate of the deceased spouse must make an election on a timely filed estate tax return for the surviving spouse to be able to use the DSUEA. On the estate tax return, the executor must compute the amount of the DSUEA for which the election is being made. Once made, the election is irrevocable. It's important for practitioners to remember that the deceased spouse's estate will need to file an estate tax return regardless of the value of the estate to make the portability election.

It also should be noted that the definition of DSUEA references the basic exclusion amount of the “last such deceased spouse,” not the basic exclusion amount of the last such deceased spouse with respect to which an election to use the DSUEA has been made. Thus, it appears that if a subsequent spouse dies with less unused basic exclusion amount than a prior deceased spouse, the greater DSUEA of the prior spouse can't be preserved for the surviving spouse by not making an election with respect to the subsequent deceased spouse. Regulations clarifying this issue would be helpful.

Second, Section 2010(c)(5)(B) provides that the returns of a deceased spouse continue to be open to IRS examination past the expiration of the statute of limitations for the IRS to determine the proper amount of DSUEA.

Planning Implications

Portability is certainly a useful addition to the estate tax regime. It will be useful, for example, for those estates in which adequate lifetime planning wasn't done, (for example, the decedent died intestate or all property was given outright to his spouse). Until now, practitioners were essentially limited in such cases to the use of qualified disclaimers to fully utilize the decedent's applicable exemption amount. Portability will also be useful in those estates in which the decedent didn't own sufficient assets to fully utilize his applicable exemption amount, which is now more likely to occur with the increase in such amount. Despite these advantages, there are several reasons why portability doesn't make the bypass trust obsolete and thus practitioners, as a general rule, still should incorporate it as part of the basic estate plan for married couples.

Generation-skipping transfer (GST) tax exemption isn't portable

The 2010 Tax Act didn't extend the portability provisions to the GST tax exemption. Thus, a surviving spouse can't use any unused GST tax exemption of a pre-deceased spouse. Although a reverse qualified terminable interest property (QTIP) election may be available to prevent unused GST tax exemption from being wasted, the most effective use of the GST tax exemption is to apply it to a trust that won't be subject to tax in the surviving spouse's estate and that descendants can use during the surviving spouse's life — that is, the bypass trust.

Appreciation on assets during a surviving spouse's life

A bypass trust also shelters any appreciation on the trust assets during the surviving spouse's life from estate tax upon his death.

Example 7: Husband dies in January 2011 leaving $4 million outright to his spouse. This outright bequest qualifies for the estate tax marital deduction and thus none of Husband's basic exclusion amount is used. Wife has $4 million of her own assets. Wife dies in December 2012. At the time of Wife's death, the $4 million received from Husband has increased in value to $6 million and Wife's own assets have increased to $5 million, for a total estate value of $11 million.

  • Wife's applicable exclusion amount is equal to her own $5 million basic exclusion amount (assuming no inflation increase) plus Husband's $5 million of DSUEA, for a total of $10 million.
  • Thus, the value of the assets in Wife's estate exceed her applicable exclusion amount by $1 million, triggering an estate tax.

Example 8: Same facts as in Example 7, except instead of leaving the $4 million outright to his spouse, Husband leaves such amount to a bypass trust for Wife's benefit and as such uses $4 million of his basic exclusion amount.

  • At Wife's death, her applicable exclusion amount is equal to her own $5 million basic exclusion amount plus Husband's $1 million of DSUEA, for a total of $6 million.
  • Because the assets of the bypass trust aren't includible in Wife's estate, Wife's assets of $5 million are fully covered by her applicable exclusion amount and thus no estate tax is due.

Risk of failure to make a timely election

Because the executor of the first deceased spouse's estate must make an election on a timely filed estate tax return for the surviving spouse to be able to use the DSUEA, there's always a risk that portability will be lost if a proper election isn't made. The risk is greatest when an estate tax return doesn't otherwise need to be filed. By incorporating a bypass trust into the client's estate planning documents, the effective use of his applicable exclusion amount isn't subject to his executor making a timely election so long as the deceased spouse has enough assets to fully utilize his exemption.

Continuing IRS scrutiny

Because the returns of a deceased spouse continue to be open to IRS examination past the expiration of the statute of limitations for the IRS to determine the proper amount of the DSUEA, there's no finality as to how much exemption the deceased spouse actually used. This not only imposes a long-term recordkeeping burden on the surviving spouse, but also makes planning for the surviving spouse's own estate difficult. Thus, using a bypass trust can prevent the surviving spouse from possibly being subject to a time-consuming and costly re-examination by the IRS years after the deceased spouse's death.

Greater tax benefit from later marriages

As indicated above, portability only applies to the unused exclusion amount of the “last” deceased spouse of the surviving spouse and thus the unused exemptions from several marriages can't be accumulated. There's no limit, however, to the number of bypass trusts that can be created for one person. Though increasing the potential tax benefits from subsequent marriages likely isn't a high priority for most clients, it's an advantage of the bypass trust that practitioners should bear in mind.

Non-tax benefits of trusts

There are non-tax benefits of retaining property in trust rather than distributing it outright. Foremost among these are the creditor protection and planning for disability provided by trusts.

In light of the foregoing, although the 2010 Tax Act's portability provision is a beneficial addition to the IRC, practitioners shouldn't “bypass” the bypass trust for married couples.

Endnotes

  1. Technically, Section 303(a) of the The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the 2010 Tax Act) amends Section 2010(c)(2), as amended by Section 302(a) of the 2010 Tax Act.
  2. Because the deceased spousal unused exclusion amount (DSUEA) refers to the basic exclusion amount of the “last deceased spouse,” it would seem that remarrying alone wouldn't cause a change in the DSUEA. Rather, the next spouse must also die to be the “last deceased spouse.”
  3. This same issue arises outside the context of the DSUEA. For example if a client uses $5 million of the applicable exclusion amount in 2011 or 2012, and then Congress doesn't enact new legislation increasing the applicable exclusion amount, the client's applicable exclusion amount for purposes of the estate tax would only be $1 million. Thus, $4 million in gifts could be subject to estate tax.

Deborah V. Dunn is a partner in the Chicago office of Kirkland & Ellis LLP

2010 Tax Act Amendments

They add new paragraphs to IRC Section 2010(c) and amend IRC Section 2505(a)

IRC Sections 2010 (c)(2), (3) and (4) and Section 2505 (a) provide:

(2) APPLICABLE EXCLUSION AMOUNT. — For purposes of this subsection, the applicable exclusion amount is the sum of —

  1. the basic exclusion amount, and

  2. in the case of a surviving spouse, the deceased spousal unused exclusion amount.

(3) BASIC EXCLUSION AMOUNT. —

  1. IN GENERAL. — For purposes of this subsection, the basic exclusion amount is $5,000,000.

  2. INFLATION ADJUSTMENT. — In the case of any decedent dying in a calendar year after 2011, the dollar amount in subparagraph (A) shall be increased ….

(4) DECEASED SPOUSAL UNUSED EXCLUSION AMOUNT. — For purposes of this subsection, with respect to a surviving spouse of a deceased spouse dying after December 31, 2010, the term “deceased spousal unused exclusion amount” means the lesser of —

  1. the basic exclusion amount, or

  2. the excess of —

    1. the basic exclusion amount of the last such deceased spouse of such surviving spouse, over

    2. the amount with respect to which the tentative tax is determined under section 2001(b)(1) on the estate of such deceased spouse.

Section 2505(a) now reads:

In the case of a citizen or resident of the United States, there shall be allowed as a credit against the tax imposed by section 2501 for each calendar year an amount equal to

  1. the applicable credit amount in effect under section 2010(c) which would apply if the donor died as of the end of the calendar year, reduced by

  2. the sum of the amounts allowable as a credit to the individual under this section for all preceding calendar periods.