What Is a Bypass Trust?

A Bypass Trust is a type of irrevocable trust that allows the grantor to directly or indirectly transfer assets for his or her benefit during his or her lifetime. It is used to avoid the federal estate tax known as “the death tax” in the United States.  By being able to transfer assets during one’s lifetime, Bypass Trusts may also protect against Medicaid spend-down requirements in order not to disqualify an individual for benefits.  Bypass trusts are sometimes referred to as Credit Shelter Trusts or Bypass Annuity Trusts.

What Purpose Does a Bypass Trust Serve?

A Bypass Trust serves as a mechanism for transferring assets to the next generation without gift taxes and/or estate taxes.  By using a Bypass Trust, assets may be placed into the trust and distributed to the beneficiaries of your choosing while avoiding estate taxes on both Federal and State levels.  By transferring assets to this trust during your lifetime, you can retain control of those assets until death. This helps protect against incapacity issues that may arise later in life.

How Does Bypass Trust Work?

The Bypass Trust can be funded with cash or it can also be funded with other assets such as real estate, securities, and insurance.  Each Bypass Trust is drafted to best suit the wishes of the Grantor. The Bypass Trust will continue to exist even after death. This trust will provide a payment to the Bypass Trust Beneficiary if certain conditions are met.  If the Bypass Trust Beneficiary dies, then the Bypass Trust Assets will pass on to their heirs or beneficiaries.  The Bypass Trust can allow for flexibility in planning while minimizing gift and estate tax exposure. 

How Long Does a Bypass Trust Last?

A Bypass Trust is irrevocable and therefore will last for the duration of the Bypass Trust Beneficiary’s life.  If, however, you want to end this trust at some point in time after the Bypass Trust Beneficiary has died then you must say that within your Bypass Trust Documents. If no end date is specified, the Bypass Trust will continue in perpetuity

What Are Bypass Trust Assets?

The Bypass Trust Assets can include cash, real estate, securities, and insurance. In some cases, it may also include interests in private businesses or closely held corporations.  By funding a Bypass Trust with non-marketable assets such as interests in private businesses or closely held corporations, transfer tax savings are maximized. 

Who Are the Bypass Trust Beneficiaries?

The Bypass Trust Beneficiary is the person who will receive benefits from the Bypass Trust. They may be changed at any time during your life through Bypass Trust Amendments.  You can even choose to distribute Bypass Trust Assets to Bypass Trust Beneficiaries in different amounts if you choose to do so. 

Bypass Trust Amendment Process 

To amend your Bypass Trust, these things should be present:

  1. Bypass Trust Documents, this includes your Bypass Trust and Bypass Trust Amendments 
  2. Bypass Trust Agreement 
  3. Three (3) witnesses 
  4. Bypass Trust Beneficiary or the person who would receive benefits from the Bypass Trust if they were to die. 

If you fail to hold these things present, then Bypass Trust Amendments may not be valid. If Bypass Trust Beneficiary becomes incapacitated or incompetent, then Bypass Trust can be amended to provide benefits to the Bypass Trust Representative until Bypass Trust Beneficiary is once again able to receive Bypass Trust benefits. 

Pros and Cons of Having a Bypass Trust

There are Bypass Trust benefits and Bypass Trust disadvantages when compared to other estate planning options. 

Pros

  • By providing for your Bypass Trust Beneficiaries as you see fit, you retain control during your lifetime and after your death. 
  • Provide maximum flexibility in designing an estate plan tailored to meet your specific needs. 
  • By transferring non-marketable Bypass Trust Assets to Bypass Trusts, the transfer tax savings are maximized. 
  • By transferring Bypass Trust Assets to your Bypass Trust Beneficiaries at different times, you can minimize estate taxes. 
  • By granting specific bequests in your Will, you retain flexibility within your estate plan should there be unexpected changes in your family or business environment. 
  • Bypass Trusts can also provide for a Bypass Trust Beneficiary’s special needs or reduce estate taxes in times of financial distress. 

Cons

  • By funding Bypass Trust Assets, assets will be removed from your estate and cannot be reclaimed. 
  • If Bypass Trust Assets are distributed to Bypass Trust Beneficiaries before the Grantor has died, those distributions may increase income tax liability for those Bypass Trust Beneficiaries. 
  • Bypass Trusts can only be funded during your lifetime and cannot be funded after you die. 
  • With Bypass Trusts, there is no “Step Up in Basis” at death so Bypass Trust Beneficiaries may be subject to Capital Gains taxes on Bypass Trust Assets.

Bypass Trust Planning Tips

The following are the things to consider before having a Bypass Trust:

  1. Consider whether you should create Bypass Trusts for each Bypass Trust Beneficiary and Bypass Trust Assets. 
  2. Make sure that you choose Bypass Trust Beneficiaries that will benefit from the Bypass Trust Assets. 
  3. If Bypass Trust Assets are given to Bypass Trust Beneficiaries at different times, it may be able to reduce estate taxes. 
  4. If Bypass Trust Assets are given to Bypass Trust Beneficiaries at different times, it may be able to reduce gift tax liability on Bypass Trust Beneficiaries. 
  5. Make sure that you choose Bypass Trust Beneficiaries that will benefit from the Bypass Trust Assets and who will not waste or underutilize Bypass Trust Assets. 
  6. You should create a Bypass Trust when you want to provide for Bypass Trust Beneficiaries in a manner different from what is provided in your Will or Revocable Living Trust. 
  7. You should create Bypass Trusts for Bypass Trust Beneficiaries who you do not want to benefit from Bypass Trust Assets until a certain age, such as when Bypass Trust Beneficiary reaches the age of majority.

Key Takeaways 

When Bypass Trusts are created during a lifetime, the Bypass Trust assets cannot be reclaimed by the Grantor.  By creating Bypass Trusts for Bypass Trust Beneficiaries who you do not want to benefit from Bypass Trust Assets until a certain age, such as when Bypass Trust Beneficiary reaches the age of majority, those assets can be reclaimed by the Grantor.  This Trust is used to avoid the federal estate tax known as “the death tax” in the United States. 

Bypass Trust is a method of avoiding federal estate taxes (more commonly known as the death tax).
You should consider having Bypass Trust when you want to provide for Bypass Trust Beneficiaries in a manner different from what is provided in your Will or Revocable Living Trust.
You should consider Bypass Trust Beneficiaries who will benefit from Bypass Trust Assets and who will not waste or underutilize Bypass Trust Assets.
You may want to consider Bypass Trust Assets that are likely to appreciate, such as Bypass Trust stock or Bypass Trust real estate.
Bypass Trust Beneficiaries can receive Bypass Trust cash, Bypass Trust real estate, or Bypass Trust stock.

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.