Do I Need a Bypass Trust?

The Two Core Questions

 

Before choosing any structure, it helps to be clear about your primary concern.

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1. Estate tax protection

Do you need to preserve both spouses’ estate tax exemptions?
 

2. Control after death

Do you want to make sure your children or other beneficiaries ultimately receive specific assets, even if your spouse later remarries or changes their plan?

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Once you know which concern matters most, the right design becomes much clearer.

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1. If the Concern is Estate Taxes​

 

For most families, it is possible to preserve the full combined estate tax exemption — currently around $30 million per couple — without using a bypass trust.

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There are two main approaches:

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Bypass Trust

At the first spouse’s death, a bypass trust is funded with the deceased spouse’s exemption amount. Those assets are excluded from the surviving spouse’s estate.

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The tradeoff is significant:

• The assets do not receive a second step-up in basis at the surviving spouse’s death.

• This can result in large capital-gains taxes when the children later sell the assets.

• Administration is more complex and restrictive.

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Portability (Form 706)

Instead of funding a bypass trust, the surviving spouse can file Form 706 to claim the deceased spouse’s unused exemption (called DSUE).

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With portability:

• The survivor keeps both their own exemption and the DSUE.

• The assets remain in the survivor’s estate.

• At the survivor’s death, the assets receive a second step-up in basis, eliminating capital gains.

• Trust administration is simpler.

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Bottom line on taxes:
Both bypass trusts and portability preserve the full exemption. The key difference is that bypass trusts lose the second step-up in basis, while portability preserves it. For most families, portability is the better tax result.​

 

2. If the Concern Is Control

Some clients are less worried about estate taxes and more focused on making sure their children actually inherit their share.

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The Weakness of Many Bypass Trusts

In many traditional designs:

• The surviving spouse chooses which assets fund the bypass trust.

• Attorneys often recommend funding it with cash to avoid capital-gains issues.

• Cash is also the asset most likely to be spent during life.

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The result is that little may be left for the children.

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A Better Approach: Inheritance Agreements

Our trusts allow for an Inheritance Agreement that locks in specific, traceable assets, such as:

• A residence

• A brokerage account

• Other identifiable property

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These assets:

• Are easier to track

• Are less likely to be spent during life

• Still qualify for a step-up in basis at the survivor’s death

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We also include assets of last resort language, making clear that:

• The surviving spouse must spend their other assets first

• Before using assets intended to pass to the children or other beneficiaries

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Bottom line on control:
If your main goal is protecting your children’s inheritance, a carefully designed spousal restriction trust works better than a bypass trust.

 

What About a QTIP Election?

 

Some clients are told:

“My last attorney said I could take a QTIP election and still get a step-up.”

 

That is correct.

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With a QTIP trust:

• All income must be paid to the surviving spouse for life.

• The assets are included in the survivor’s estate.

• They receive a step-up in basis at the survivor’s death.

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Some trusts allow the executor to choose:

• Treat the trust as a bypass trust (excluded from the estate), or

• Elect QTIP treatment (included, with a step-up).

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Important distinction:
A QTIP election provides basis flexibility, but it does not double your exemption.
Doubling the exemption is accomplished through portability, not through QTIP.

 

Why Our Inheritance Agreement Design Is Better

 

Our design improves on both bypass and QTIP models.

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Under our approach:

• All assets pass to the surviving spouse.

• The surviving spouse cannot change the ultimate beneficiaries of restricted assets.

• The assets remain in the survivor’s estate and receive a second step-up in basis.

• The survivor can file Form 706 to elect portability, preserving the deceased spouse’s unused exemption.

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We recommend restricting:

• Homes

• Brokerage accounts

• Other traceable assets that are less likely to be spent during life

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This combination:

• Secures the children’s inheritance

• Preserves full basis step-up

• Captures both spouses’ exemptions

• Avoids unnecessary trust complexity

 

Example: Why the Second Step-Up Matters

 

Assume:

• A house is worth $2,000,000 at the first spouse’s death.

• Original purchase price was $500,000.

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At the first death, the basis steps up to $2,000,000.

Ten years later, the house is worth $3,500,000.

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If the House Is in a Bypass Trust

• Basis remains $2,000,000.

• Children sell for $3,500,000.

• Taxable gain is $1,500,000.

• At combined federal and California rates (~39%), tax is about $585,000.

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If the House Is in a Portability / Spousal Restriction Trust

• At the survivor’s death, basis steps up again to $3,500,000.

• Children inherit with no taxable gain.

• If sold immediately, no capital-gains tax is due.

 

Final Takeaway

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• Bypass trusts and portability both preserve the estate tax exemption.

• Bypass trusts often come with two major costs:

  • Loss of the second step-up in basis

  • Weaker protection for children

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Our inheritance agreement format combines the best of both worlds:

• Double the exemption through portability

• Full second step-up in basis

• Locked-in inheritance for your beneficiaries

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In real terms, this can save your heirs hundreds of thousands of dollars in unnecessary tax, while providing stronger protection for your family’s long-term plan.