Do the assets of a bypass trust need to be included in the value of an estate?
Taxpayer Says: The assets of the trust should not be included in the estate because the trustee did not have a general power of appointment.
Internal Revenue Service Says: The trust document gave the trustee access to the trust assets that created a general power of appointment. The assets of the trust are part of the estate.
From Internal Revenue Code Section 2001: Imposes a tax on the transfer of the taxable estate of all persons who are citizens or residents of the United States at the time of death.
From Internal Revenue Code Section 2041(a)(2): The gross estate includes property with respect to which the decedent had a general power of appointment created after October 21, 1942.
From Internal Revenue Code Section 2041(b)(1): Generally defines a general power of appointment as “a power which is exercisable in favor of the decedent, his estate, his creditors, or the creditors of his estate.”
From Federal Tax Regulation 20.2041-1(c)(2): A power to consume, invade, or appropriate trust income, corpus, or both for the decedent’s benefit is not deemed a general power of appointment if it is “limited by an ascertainable standard relating to the health, education, support, or maintenance of the decedent.”
From Estate of Little v. Commissioner, 87 T.C. 599, 601 (1986): This exception [the exception provided in Reg. 20-2041] entails two requirements: First, the power of appointment must be limited by an ascertainable standard; and second, that standard must relate solely to the decedent’s health, education, support, or maintenance.
THE CAUSE OF THE DISPUTE
A bypass trust, or credit shelter trust, is an estate planning technique you can use to take full advantage of the estate tax exclusion (currently $5 million), which is the amount you can leave to your heirs free of estate tax.
The bypass trust is funded at your death, and gives your spouse the right to take withdrawals of trust income or principal during his or her lifetime. After your spouse’s death, the trust can continue for the benefit of your children or other beneficiaries, or the assets can be distributed to them.
In general, someone with the power to take withdrawals of trust assets for their own benefit would have to include the assets of the trust in their estate, since they effectively control the trust. However, tax law provides an exception to the rule when the right to take withdrawals is limited to specific purposes, such as health, education, support or maintenance. [Editorial note: Other exceptions are also available.]
In this case, which involves an estate created in 2004 in Mississippi, a credit shelter trust was established when the taxpayer’s husband died. The trust’s wording gave the taxpayer the right to take withdrawals of trust income and assets for the “necessary maintenance, education, health care, sustenance, welfare or other appropriate expenditures, taking into consideration the standard of living to which [she and the other beneficiaries] are accustomed”.
When the taxpayer died, her executor did not include the trust assets on the estate tax return because she believed this wording met the exception as provided in the law.
The IRS says the term “welfare or other appropriate expenditures” goes further than intended by the exception, and therefore the taxpayer had a general power of appointment over the trust. The IRS contends the trust assets should be included in the taxpayer’s estate, resulting in additional estate tax due of $716,000.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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