In California, married couples typically create a joint Trust—One Trust where both husband and wife are the settlors, beneficiaries, and trustees. They transfer all of their property into the joint Trust and the Trust is revocable during their lifetime. That means it can be changed or terminated while they both are alive. Nothing set in stone here. At least not yet.
And then a spouse dies. That’s when sub-trusts come to life. What are sub-trusts? They are newly created Trusts that hold some portion of the assets previously owned by husband and wife. The sub-trusts to be created after the death of one spouse are spelled out in the joint trust document. They direct the trustee on how to create the necessary sub-trusts.
What Are Sub-Trusts?
This is how it works. The most common sub-trusts are referred to as Survivor’s Trusts and Bypass Trusts.
The Survivor’s Trust receives all the assets belonging to the surviving spouse—hence the name Survivor’s Trust.
The Bypass Trust receives all the assets belonging to the spouse who died, up to a maximum of that person’s estate tax exclusion amount.
In 2022, every person can transfer up to $12.06 million at death without incurring estate tax. Thus, the Bypass Trust receives everything the decedent spouse owed; provided that, it does not exceed $12.06 million. The Bypass Trust will bypass estate taxes when the second spouse dies—hence the name Bypass Trust. Once assets are funded into a Bypass Trust, they will never be subject to estate tax on the surviving spouse’s death.
For those lucky few who have assets that exceed $12.06 million, there is also a Marital Trust (also referred to as a QTIP Trust). The Marital Trust receives that portion of the deceased spouse’s assets that exceed $12.06 million.
As you can imagine, many Trusts that provide for a Marital Trust won’t need to create it because the deceased spouse’s assets will be valued at less than $12.06 million. But many Trusts have Marital Trust provisions anyway. That’s fine, they’re just not used if they are not needed.
By the way, some joint Trusts will state that upon the death of the first spouse ALL assets pass to the Survivor’s Trust. That makes life much easier for the surviving spouse, but it could also result in tax consequences if the estate is valued at more than $12.06 million. The other problem with all assets passing to the Survivor’s Trust is the lack of control. Let’s talk about control.
The Survivor’s Trust is usually revocable and amendable during the survivor’s lifetime. That means the Trust terms can be changed or altered in any way. Or the Trust can be terminated altogether. The Bypass Trust, however, is irrevocable. That means it cannot be amended, changed, or terminated after the first spouse dies. The Bypass Trust will usually allow for income and principal to be distributed to the surviving spouse for his or her support, but the ultimate beneficiaries of the Bypass Trust after the surviving spouse dies cannot be changed.
Let’s run through an example. Assume that Hank and Wanda create a joint trust. They own around $2.5 million of assets when the trust is created, and they transfer all of their assets into the new trust. Hank has two children from a prior marriage: Adam and Barbara. And Wanda has one child from a prior marriage: Charlie. Under the joint trust, the document states that the assets are held for Hank and Wanda’s benefit until they die.
One spouse dies, the Trust requires the creation of a Survivor’s Trust and a Bypass Trust. Since all of Hank and Wanda’s property is community property, one-half of the total Trust assets will transfer to the Survivor’s Trust on the first spouse’s death. And the other one-half will transfer to the Bypass. Trust. Ten years after the Trust is created, Hank dies. The total Trust assets at the time of Hank’s death equal around $5 million.
The trustee of the Trust, who is probably Wanda, now has the obligation of creating two new sub-trusts. The Survivor’s Trust will receive half of the Trust assets, or $2.5 million worth of property. The Bypass Trust will receive the other half, also $2.5 million. Wanda now becomes trustee of by the Survivor’s Trust and the Bypass Trust. But her rights to the assets of each Trust are very different.
When it comes to the Survivor’s Trust, she has free access to the assets of that Trust and can do anything she likes with it. She can also change the beneficiaries. For example, Wanda could do a Trust amendment and leave the Survivor’s Trust to Charlie only. She can cut out Adam and Barbara.
When it comes to the Bypass Trust, Wanda’s powers are far more limited. For starters, if Adam and Barbara are the beneficiaries of the Bypass Trust after Wanda dies, that cannot be changed (assuming there is no power of appointment, which is a topic that goes beyond this article). Also, Barbara can only use the assets of the Bypass Trust according to the Trust terms.
Most Bypass Trusts will limit the surviving spouse’s access to the Trust assets to only so much as is needed for her support and maintenance. And many Bypass Trusts will have the added requirement that the surviving spouse must use her own assets first. In other words, the assets of the Survivor’s Trust must be used before the assets of the Bypass Trust. In any event, the distribution standards and limitations of the Bypass Trust must be followed.
As you can see, Survivor’s Trusts and Bypass Trusts are very different. The Bypass Trust allows the first spouse to die to exert control and limitations beyond the grave. Whereas the Survivor’s Trust has an open door where the surviving spouse can do anything she likes with those assets. Saying the Bypass Trust provides for control may sound harsh, but it does benefit Hank’s children in the example above.
Control should be thought of as preserving the inheritance, the legacy, of both spouses’ children so that unanticipated changes after one spouse dies do not harm the deceased spouse’s children. It can provide for a more equitable result after one spouse dies. But that control comes at a cost because the surviving spouse does not have free, unfettered access to the entire Trust estate any longer. Thus, using a Bypass Trust is a personal choice.
Do you want control and protection for all of the children (Bypass Trust) or freedom and choice for the surviving spouse (no Bypass Trust)? The choice is yours.
