Saturday, October 17, 2009

WSJ Article On How Estate Tax Exemption Could Mean There's A Trap In The Bypass Trust Or Credit Shelter Provision Of Your Will

On October 15, 2009, the Wall Street Journal had an article entitled "Is There A Trap Lurking In The Language Of Your Will?" The article is a good reminder as to why it is critical to have your will reviewed every few years, especially if there is a significant event in your life or the law changes.

Why could there be a "trap" in your will? Since 2001, the federal estate tax exemption has stepped up from $675,000 to its current level of $3.5 million per individual or, with planning, $7 million per couple. Thus, people who have not updated their wills could have some unintended consequences if this exemption increase has not been taken into consideration.

For example, in many wills and trusts, lawyers often put a "credit shelter" or "bypass" trust provision into the will of each partner in a married couple. This allows the couple to take full advantage of both individual exemptions. At the death of the first spouse, some assets go into a bypass trust that the other can draw on if necessary. These assets escape tax at the second spouse's death and pass directly to heirs.

As the WSJ article explains, when the estate tax exemption was $2 million and below, bypass trusts were especially important to those who were affluent but not hugely wealthy. Used properly, they helped shelter the greater part of a couple's assets from estate tax. If each spouse instead left all his or her assets outright to the other, in many cases the value of one exemption was lost and unnecessary taxes had to be paid upon the death of the second spouse.

The current trap mainly affects those couples who benefited most from bypass trusts in the past—those with up to, say, $4 million in assets. The problem lies in the wording of many wills drafted even a few years ago, which often directs that the "full amount" of the estate tax exemption go into the bypass trust when the first spouse dies. If the language of the will hasn't changed while the exemption has grown, the bulk of a couple's assets could in some cases wind up in a bypass trust after the death of the first spouse, leaving the survivor with little or nothing outright.

For example: A couple with $4.5 million of assets made wills in 2002, when the exemption was $1 million. At the time, the wife's share consisted of their $750,000 home and $250,000 in other assets, with the rest belonging to her husband. The will's language directs the full exemption amount into a trust at his death, with the income to the spouse for life and the remainder to heirs—which, if he died in 2002, meant $1 million would go into the bypass trust, and $2.5 million would transfer to his wife. But if he dies in 2009 or 2010—assuming the exemption remains at $3.5 million—she would get nothing outright. All of his assets would go directly to the bypass trust.

One New York estate planning attorney was quoted in the article discussing a bad family situation where the husband signed a will in 2000 leaving the "full exemption" amount in trust for his children and the rest of his estate to his wife, thinking this would split his $2 million estate down the middle. When he died in 2008 without updating the will, the exemption had risen to $2 million, so the bulk of the estate bypassed the wife. She was left only with the house and some cash of her own.

As the article notes, writing a will or trust is not something you do once, place in a safety deposit box and then forget about it. It needs to be reviewed when the law changes, when there are life changes and every few years to ensure it reflects your current intentions and plans. Updating your will and trust does not have to be expensive and can save you and your family from facing unintended consequences.

Posted by Henry Moravec, III. Any questions or comments should be directed to: hm@moravecslaw.com or (626) 793-3210. The firm website is