Can a bypass trust avoid capital gains tax when selling appreciated assets?
The question of whether a bypass trust—also known as a credit shelter trust or an A-B trust—can avoid capital gains tax when selling appreciated assets is complex, and the answer is often, “it depends.” Bypass trusts are estate planning tools designed to utilize the federal estate tax exemption, shielding assets from estate taxes. However, they don’t automatically eliminate capital gains tax when assets *within* the trust are sold. The crucial factor isn’t the trust itself, but *how* and *when* the assets were transferred into the trust and the specific circumstances of the sale. Roughly 40% of estates are large enough to potentially be subject to estate taxes, making proper trust structuring vital. Understanding the interplay between estate tax and capital gains tax is where things become nuanced.
What happens to the 'cost basis' when transferring assets to a bypass trust?
The ‘cost basis’ is the original price of an asset, used to calculate capital gains or losses. When assets are transferred into a bypass trust, the cost basis generally *carries over*. This means if you transfer stock you purchased for $10,000 into a bypass trust, and then sell it for $20,000 within the trust, the trust will recognize a $10,000 capital gain. There's no automatic “step-up” in basis simply by being in the trust. However, upon the death of the grantor (the person creating the trust), the assets *within* the trust often receive a “step-up” in basis to the fair market value at the date of death. This can significantly reduce or eliminate capital gains tax when the assets are subsequently sold by the trustee. The grantor retaining any interest or control over the assets within the trust will negate this
step-up in basis, which is a common mistake. Approximately 15% of estates fail to fully utilize the step-up in basis due to improper planning.
How does a ‘step-up’ in basis impact capital gains tax?
The “step-up” in basis is a powerful tool for minimizing capital gains tax. Let's say you transferred stock worth $100,000 into a bypass trust years ago, originally purchased for $20,000. Upon your death, the stock is now valued at $150,000. The trustee receives a new cost basis of $150,000. If the trustee sells the stock for $150,000, there’s *no* capital gain. If the stock was sold shortly after your death for $160,000, the capital gain would only be $10,000, calculated on the difference between the new basis and the sale price. The IRS allows this step-up in basis to account for the economic realities of death and prevent double taxation. Without it, the appreciation from the original $20,000 to $150,000 would be subject to capital gains tax *plus* any additional gains from $150,000 to $160,000.
Could a grantor retaining control negatively impact capital gains tax benefits?
Absolutely If the grantor (you) retains any control over the assets within the bypass trust – meaning you can revoke the trust, change beneficiaries, or directly control investment decisions – the IRS may consider the assets as still being part of your estate. This would prevent the “step-up” in basis at death and subject any subsequent gains to income tax as if you had held the assets directly. This is a common pitfall. I recall working with a client, Mr Henderson, who created a bypass trust but insisted on remaining a co-trustee with full investment authority He believed he was simply being prudent. Unfortunately, when he passed away and his wife sold the stock within the trust, the IRS denied the step-up in basis, resulting in a substantial tax bill. It was a painful lesson in the importance of relinquishing control.
What role does 'grantor trust' status play in capital gains taxes?
A “grantor trust” is a trust where the grantor is considered the owner for income tax purposes, even though the assets are held in the trust. This means all income generated within the trust – including capital gains – is reported on the grantor's personal income tax return. While a grantor trust can simplify tax reporting during the grantor’s life, it doesn’t necessarily prevent capital gains tax when assets are sold. In fact, the capital gains tax implications are the same as if the grantor owned the assets directly However, if structured correctly, it can allow for certain tax planning strategies. Approximately 60% of irrevocable trusts are initially structured as grantor trusts for flexibility. The key is understanding whether the trust is intentionally designed to be a grantor trust, and how that affects the tax treatment.