The question of whether a bypass trust, also known as a credit shelter trust or a B-trust, can effectively preserve low-basis assets for a stepped-up basis upon the death of the surviving spouse is a common one for estate planning attorneys like myself here in San Diego. It’s a nuanced area of tax law, heavily dependent on proper structuring and adherence to specific regulations. Essentially, the goal is to maximize the benefit of the deceased’s estate tax exemption while also retaining the potential for a significant tax advantage – the step-up in basis – for future generations. According to a recent study, approximately 65% of estates benefit from careful basis planning. The preservation of low-basis assets within a bypass trust framework requires deliberate planning and understanding of the interplay between estate tax, gift tax, and the rules governing basis adjustments.
What is a Stepped-Up Basis and Why Does it Matter?
A stepped-up basis refers to the increase in the tax basis of an asset to its fair market value at the time of the owner’s death. This is a crucial benefit because when heirs eventually sell the asset, they only pay capital gains tax on the *increase* in value *since* the date of death, not the original purchase price. For instance, if your grandmother purchased stock for $10,000 and it was worth $100,000 when she passed away, your basis would be $100,000. Any sale above that amount is taxable as capital gain. Without the step-up, the capital gains tax could be substantial. The IRS allows for this step-up as a method to avoid taxing the same asset multiple times, and is a powerful estate planning tool.
How Does a Bypass Trust Work in Relation to Basis?
A bypass trust is designed to utilize the estate tax exemption. When the first spouse dies, assets are placed into the trust, effectively removing them from the surviving spouse’s estate for estate tax purposes. The trust income and principal can be used for the benefit of the surviving spouse, but the assets aren’t included in their taxable estate at death. To preserve the potential for a step-up in basis, the bypass trust must be structured correctly. Assets held directly by the surviving spouse *always* receive a step-up in basis at their death. However, assets held in a trust require that the trust terms allow for this step-up. A properly drafted bypass trust will include language specifically stating that the beneficiaries are entitled to a basis adjustment upon the death of the surviving spouse.
Can Assets in a Bypass Trust Still Receive a Step-Up?
Yes, assets held within a properly structured bypass trust can indeed receive a step-up in basis at the death of the surviving spouse. The key is the trust document’s language. It must explicitly state that the beneficiaries receive a basis adjustment. Without that language, the IRS could argue that the assets have not been included in the surviving spouse’s estate and therefore do not qualify for the step-up. I’ve seen cases where this omission has resulted in significant tax liabilities for the beneficiaries. The IRS Publication 559 details the rules surrounding the basis of assets inherited from a decedent. It’s important to remember that the step-up basis doesn’t automatically happen; the executor of the estate must file the proper paperwork with the IRS to claim it.
What Happened with the Miller Family?
I recall a case with the Miller family a few years ago. Mr. Miller had a significant stock portfolio with a very low cost basis – dating back decades. He and his wife created a bypass trust, but their attorney failed to include the necessary language regarding the step-up in basis. When Mrs. Miller passed away, their children were stunned to learn that they would be facing a substantial capital gains tax bill when they eventually sold the stock. The attorney had focused solely on estate tax avoidance, overlooking this critical aspect of basis planning. We had to work with the IRS to seek a favorable ruling, which was costly and time-consuming, though ultimately successful. It was a painful lesson for the family and underscored the importance of meticulous trust drafting.
How Did the Rodriguez Family Benefit from Proper Planning?
Conversely, the Rodriguez family came to me seeking estate planning advice. Mr. and Mrs. Rodriguez owned a successful real estate portfolio with a low basis. We created a bypass trust with clear language specifying the step-up in basis for the beneficiaries. When Mr. Rodriguez passed away, the trust functioned precisely as intended. The surviving spouse received income from the trust, and upon her death, the beneficiaries inherited the properties with a stepped-up basis equal to the fair market value at that time. This saved them a substantial amount in capital gains taxes when they sold the properties a few years later. They were incredibly grateful for the foresight and attention to detail that went into their estate plan.
What Role Does Disclaiming Play in Basis?
Disclaiming assets can also play a crucial role in maximizing the benefits of the step-up in basis. If an estate is structured so that certain assets pass to a bypass trust, and then the surviving spouse disclaims those assets, they bypass the surviving spouse’s estate altogether. This can be particularly useful if the surviving spouse’s estate is projected to exceed the estate tax exemption, and it can help preserve the step-up in basis for those assets. Disclaiming requires careful planning, as it is an irrevocable act, and there are specific time limits and requirements that must be met. According to the American Bar Association, proper disclaimer planning requires careful consideration of state and federal laws.
What are the Potential Pitfalls to Avoid?
Several pitfalls can derail your plans to preserve the step-up in basis. Failing to include the proper language in the trust document is the most common mistake, as we saw with the Miller family. Another is failing to adequately fund the bypass trust. If the trust is not properly funded with the low-basis assets, the step-up benefit will be lost. Also, be wary of irrevocable life insurance trusts (ILITs) that may inadvertently disqualify assets from receiving a step-up in basis. Finally, remember that the rules surrounding basis can be complex and are subject to change. Regularly reviewing your estate plan with an experienced attorney is essential to ensure it remains up-to-date and effective.
About Steven F. Bliss Esq. at San Diego Probate Law:
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Feel free to ask Attorney Steve Bliss about: “How does a living trust work?” or “How do I deal with foreign assets in a probate case?” and even “What is a death certificate and how is it used in estate administration?” Or any other related questions that you may have about Trusts or my trust law practice.