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Balancing estate tax and capital gains tax liability

In our last post, we explored the issue of income tax savings with respect to bypass trusts. In this one, we’ll look at a particular strategy to allow beneficiaries of a bypass trust avoid capital gains tax on assets they receive when a surviving spouse (their father or mother) dies.

Bypass trusts, of course, allow beneficiaries to receive trust assets without estate tax consequences for the surviving spouse. Typically, though, the beneficiaries will receive their respective portion of the trust assets upon the death of the surviving spouse and will owe capital gains tax. 

A way to avoid that is to transfer the trust to the surviving spouse’s estate and grant him or her a power of appointment, which allows them to control the trust’s assets and beneficiaries. That means that the trust is considered part of the surviving spouse’s estate at his or her death, and when that happens, the trust will not be subject to capital gains tax on immediate distributions.

To make this worthwhile though, estate tax must also be considered. Surviving spouse’s that have plenty of leftover estate tax exemption to accommodate the trust assets can make this work. If there isn’t enough leftover to make it work, the surviving spouse will need to consider how they want to balance out their own estate tax liability with their beneficiaries’ capital gains tax liability.

Considerations like this are important to work with in estate planning. Tax considerations must be taken as a whole, rather than parts in isolation. An estate planning strategy may work well from an estate planning perspective, but not necessarily from an income tax or capital gains tax perspective.

One benefit of working with an experienced attorney is that these interactions will be more clear and easier to overcome. 

Source: Wall Street Journal, “Avoiding a Tax Hit From a Bypass Trust,” Austin Kilham, September 5, 2013.