Bypass the Bypass Trust: Part II


Question: Last week you wrote that a bypass trust may no longer be necessary and that married couples should ask their estate planning attorney to review their living trust and make changes if appropriate.  When my father died my Mom and Dad’s estate was split into two trusts, a survivor’s trust and a bypass trust.  The purpose of this split was to avoid estate taxes when my Mom dies.  However, her estate, including assets in both trusts, is nowhere near the current $5,430,000 exemption amount.  Does she have to keep the bypass trust or can she just transfer the bypass trust assets into her survivor’s trust?  It would certainly simplify her financial affairs.  She would have one less checkbook and one less tax return to worry about.

Answer: Your question is simple enough, but there is no simple answer, and your Mom should pay a visit to her estate-planning attorney to find out. Her attorney will ask the appropriate questions and help her decide what’s best.  It would certainly be better for her if she could simplify her finances.  It might also save you taxes when you inherit the assets in the trusts.

In order to terminate the bypass trust, all the beneficiaries would have to agree and the court would have to approve it.  If you are the only beneficiary and you think it’s a good idea, it should be fairly easy.  If there are contentious beneficiaries, especially if they are from an extended family, it probably won’t happen.  That’s because their interests are protected in the bypass trust.  If the bypass trust is terminated and the assets are transferred to the survivor’s trust, your Mom can change the beneficiaries at any time.

A bypass trust presents a tax trade-off.  It uses the first-to-die’s estate tax exemption to avoid estate taxes on the assets in that trust, but it also sets the cost basis for the bypass trust's assets to their Fair Market Value on the first-to-die’s date of death.  When your Mom dies, the cost basis of the assets in her survivor’s trust are stepped up to the Fair Market Value on her date of death.  If you sell them for that value you won’t have a capital gain.  But when you sell the assets in the bypass trust, the cost basis gets no step-up. You will be liable for capital gains tax on the difference between the sales price and the cost basis.

Question: My Mom and Dad own real estate, which they acquired in the 1970s and 1980s.  In 1992, the value of the real estate exceeded the estate tax exemption amounts.  Their attorney advised them to put the real estate holdings into a Family Limited Partnership (FLP), which they did.  They then proceeded to gift a percentage of the FLP to my sister and I each year.  We now own about half the interest in the FLP, and receive income every year.  The property has a huge unrealized capital gain but is not worth the $10,860,000 current estate-tax exemption.  What can we do?

Answer: Ask you attorney about the pros, cons, and strategies for transferring your ownership back to your parents.

Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment manager and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to