As we have previously noted on this blog, the need for a bypass trust in estate planning has dwindled since Congress made portability a permanent feature of tax law, but there are still some uses for bypass trusts, particularly at the state level, where there is still a need for many people to use such trusts to make the most of the estate tax exemption and protect their wealth.
In cases where bypass trusts are used, it is important for surviving spouses to be aware of the possible capital-gains tax consequences for trust beneficiaries at their death. Capital gains tax, of course, refers to profit realized on the sale of the trust assets. Commonly, these profits are with respect to stocks, bonds, real property. When beneficiaries receive trust assets, they will owe capital gains taxes on the profit they realize.
One way to avoid capital gains tax on assets held in a bypass trust would be to include the trust in one’s will and grant oneself a power of appointment over the trust assets. A power of appointment gives the surviving spouse the right to control both the trust’s assets and beneficiaries and, from the IRS’s perspective, makes the trust assets part of the surviving spouse’s estate at death.
Importantly, this strategy would really only work well for those who have plenty of head room left with respect to their estate tax exemption amount. If that is the case, the estate tax exemption would take care of the possibility of estate taxes, and there would be no capital gains tax on immediate distributions from the trust.
To do this, all the trust beneficiaries would need to agree to the plan. That can sometimes be a difficult prospect, but it can best be done by explaining to the beneficiaries the potential to avoid both estate and capital gains tax.
Source: Wall Street Journal, “Avoiding a Tax Hit From a Bypass Trust,” Austin Kilham, September 5, 2013.