Bypass Trusts

As a Folsom estate planning lawyer, one of my primary goals for married couples is to reduce the estate taxes that they or their families have to pay. A California bypass trust, also known as a credit shelter trust or a family trust, is an estate planning tool that allows married couples to maximize their use of the federal estate tax exemption by preserving the estate tax exemption of the first spouse to die. Here’s how a California bypass trust generally works:

1. Background on Estate Tax Exemption:
   • The federal estate tax exemption allows a deceased individual to transfer $13.61m (as of 2024) of assets to heirs or beneficiaries without incurring federal estate tax. For married couples, this exemption is portable, meaning that if one spouse doesn’t use their full exemption when they pass away, the unused portion can be transferred to the surviving spouse.
   • In California, all of the aforementioned is the same, except for the fact that there is no state estate tax exemption. As such, federal estate taxation is the only estate tax concern.
2. Purpose of a California Bypass Trust:
   • A bypass trust is typically used to ensure that both spouses can take full advantage of their individual estate tax exemptions, potentially doubling the amount that can be passed on to heirs or beneficiaries without incurring federal estate tax. This is especially relevant for larger estates.
   • Bypass trusts are often incorporated within the living trust. 
3. How It Works:
   • Upon the death of the first spouse, a California bypass trust is created to hold and manage a portion of the deceased spouse’s assets, up to the amount of their available estate tax exemption. These assets are effectively “bypassed” from the surviving spouse’s estate and are not subject to estate tax when the surviving spouse later passes away.
   • The surviving spouse retains access to the income generated by the assets in the bypass trust and may have limited access to the principal for specific purposes, such as health, education, maintenance, or support.
   • The assets held in the bypass trust are not included in the calculation of the surviving spouse’s estate for estate tax purposes, which helps preserve the federal estate tax exemption of both spouses.
   • Example: let’s suppose that John and Marie have a combined $40m estate. Let’s further suppose that John passes away first, leaving his 50% ($20m) share of the estate to Marie. The transfer will be estate tax free to Marie because they are married. When Marie eventually passes away, her heirs will be able to use her $13.61m exemption but the remaining $26.39m will be taxable. Conversely, by setting up a bypass trust, $13.61m of John’s $20m share of the estate will pass tax-free to Marie’s heirs. As such, they will be taxed on $12.78m, rather than $26.39m, netting the family significant estate tax savings. 
4. Requirements and Limitations:
   • Bypass trusts must be carefully structured to comply with California law and federal tax regulations.
   • The terms of the trust document should specify the beneficiaries and provide guidance on the distribution of trust assets.
   • Careful recordkeeping and tax reporting are essential to ensure that the trust operates correctly and takes full advantage of the available exemptions.
5. Review and Updates:
   • Estate tax laws, including exemptions, can change over time. It’s important for individuals with bypass trusts to periodically review and update their estate plans to ensure they remain in compliance with current laws and meet their intended goals.

Conclusion

Please note that federal and state estate tax laws may change and therefore it is important to stay current. As such, it’s crucial to consult with a qualified estate planning attorney in Folsom for the most up-to-date information and guidance on bypass trusts and estate tax planning strategies that are relevant to your specific situation. If you have questions about bypass trusts, contact Thapar Law at 916-579-0605 or send us a message.