Blended Family, a Sunset, and an Illiquid Business
Harold, age 72, and his second wife Dana, age 68, have combined assets of about $14.2 million: Harold $9.6 million, Dana $4.6 million. Harold's three children from his first marriage are in their 40s. The estate includes a 100% interest in a manufacturing company valued at $5.0 million with a $600,000 basis, an IRA of $2.4 million naming Dana as beneficiary, and a residence titled jointly. Assume the applicable exclusion amount is $13.61 million per person, with a scheduled reduction to roughly $7 million after 2025, and continue to assume a portability election is available. Harold wants Dana comfortable for life but wants the remaining value to reach his children; Dana is comfortable with that. Dana's own children are provided for separately.
1. Should Harold's plan rely on portability or fund a credit shelter (bypass) trust at his death? Give your reasoning under both a sunset and a no-sunset scenario.
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The honest answer is that it depends on the sunset assumption, and the plan should be built to survive either outcome.
No sunset (exclusion remains ~$13.61M+): Harold's $9.6 million is below the exclusion, so a bypass trust would produce no estate-tax saving at the first death. Portability captures his unused exclusion for Dana, whose $4.6 million plus inherited assets would then be covered by a combined exclusion. Relying on portability preserves a full basis step-up on the residence and other assets at both deaths and avoids the cost and complexity of a trust.
With sunset (exclusion ~$7M): Harold's $9.6 million exceeds $7 million. Without a bypass trust, roughly $2.6 million is exposed at his death unless portability is used - but portability is a legislative feature that could itself be restricted, and a portability-only plan with a $14.2 million combined estate plus growth is fragile. A bypass trust funded with Harold's exclusion shelters that amount and the appreciation on it from tax at Dana's death, and the exclusion used is locked in regardless of later law.
The blended-family overlay. A bypass trust is also the only structure that guarantees Harold's children receive the remainder: assets passing outright to Dana are hers to leave as she chooses, and a portability-only plan relies on her estate planning. The bypass trust gives Dana income and limited principal for her needs, then passes to Harold's children with no further tax.
Recommendation: Fund a credit shelter trust (or a disclaimer trust funded by a formula or by Dana's disclaimer, which preserves flexibility until Harold's death reveals the law in force). Disclaimers plus a marital trust give Dana security while locking in Harold's exclusion and controlling the remainder. Revisit after 2025.
2. How should the bypass trust be funded given the illiquid company interest and the IRA? Identify the traps.
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Funding choices drive both the tax result and Dana's security.
Do not fund the bypass trust with the IRA. Naming the trust as IRA beneficiary does not move value tax-free; the IRA is IRD and distributions to the trust are taxable to the trust at compressed rates. The IRA should be coordinated separately - Dana as designated beneficiary, or a conduit trust if control is needed, or a charitable beneficiary for any portion Harold wishes to give.
Be cautious about funding the bypass trust with the company stock. The low-basis $5.0 million interest would get no basis step-up at Dana's death if it sits in the bypass trust, and the trust would face a built-in gain of $4.4 million plus the cost of holding a controlling interest. Better to fund the bypass trust with high-basis assets (cash, joint residence via a formula, marketable securities) and let the low-basis company stock pass through a QTIP/marital share or outright so it gets a second step-up at Dana's death.
Formula versus pecuniary funding. A pecuniary formula funded with appreciated assets can trigger gain recognition; a fractional or minimum-worth formula avoids that, at the cost of some complexity.
Liquidity. The trust needs liquid assets to pay Dana's income; the company pays no dividends reliably. If the company must be sold, the trust needs a buy-sell arrangement and possibly life insurance to fund the marital share.
Practical answer: Fund the bypass trust with $7 million or the then-current exclusion in cash and securities, keep the company stock in the marital share or pass it with a step-up, and revisit beneficiary designations on the IRA.
3. What should Harold do about GST allocation and the timing of the plan given the scheduled reduction?
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Two decisions: whether the plan should reach grandchildren, and how much to act before the law changes.
GST. Harold's children are the current target. If any benefit is intended for grandchildren, allocate GST exemption to a separate dynasty or GST-exempt trust - but only after the estate tax planning is settled, since GST exemption is wasted if the same dollars are needed to shelter the children's generation from estate tax. Because the GST exemption is also scheduled to fall, a larger allocation made while the exclusion is high is more valuable; a timely-filed election on the gift or estate tax return is the only way to allocate, and missing it forces automatic allocation rules that may not match intent.
Timing. Harold is 72, the business is illiquid, and the law changes after 2025. Waiting forfeits the larger exclusion if it truly lapses. Actionable steps now: (1) freeze future appreciation with a gift of non-voting interests or an installment sale to an intentionally defective grantor trust, using the higher exclusion; (2) pay the gift tax cost of using more exclusion only after comparing it against the estate tax rate and the loss of basis step-up; (3) confirm the plan works if the exclusion does not fall - a disclaimer trust structure is neutral to that outcome.
Don't overreach. A plan that assumes the sunset will occur and locks assets into trusts can be worse than a flexible plan: low-basis assets in a non-grantor trust lose the step-up forever. Build in a disclaimer, a QTIP, and a power of appointment rather than committing to a single outcome.