Bypass trusts are an effective vehicle the minor aristocracy employs in stealing money from the body politic. The Estate Tax regime is the scheme under which the theft is legitimized.
The Estate Tax works by imposing a tax on individuals who die owning a certain amount. The amount is currently $2 million, but slated to go up to $3.5 million. Amounts owned beyond that amount (let's call it $2 million for purposes of discussion) are taxed at a high rate, let's call it 50%.
So, if you died owning $2.5 million worth of assets, you would get an exemption for the $2 million, and you would pay a 50% tax on the remaining .5 million. Thus, $500,000 would not be exempt, and you would pay a tax of $225,000. The amount remaining for your heirs would be $2.25 million.
However, this is an unacceptable level of taxation for the minor aristocracy. In order to avoid paying their fair share, one of the major tools of their trade, as important as the lockpick and dagger to the less well-heeled thief, is the marital deduction. The marital deduction allows someone who dies to give as much property as they want to their spouse without having to pay any estate tax on it. Goodness knows it would be terrible if a surviving spouse had to struggle to survive with only $2 million and change.
This is not good enough for the minor aristocracy, though. They run into a problem when they use the marital deduction: namely, that once the surviving spouse dies, all of the money that spouse received from the first spouse to die is in the surviving spouse's estate. That means it is subject to estate tax.
So, imagine that Harry and Wilma each owned $3.0 million of assets. Harry dies and leaves his $3 million to Wilma. Wilma now has $6 million. Because of the marital deduction, Harry pays no estate tax. When Wilma dies, though, she has $6 million. $2 million is exempted using the $2 million credit mentioned above, and the remaining $4 million is taxed. At our 50% rate, that's a $2 million tax bill. Harry and Wilma's poor heirs have to make do with only $4 million ($2 million exempted plus $2 million left after an estate tax of $2 million; 2 + (4-2) = 4).
Thankfully for the minor aristocracy, though, there is a solution to this conundrum, and a way to steal back a lot of that tax bill from the body politic. This solution is called the bypass trust. These are incredibly common "estate planning" (tax theft) devices used by the minor aristocracy, or those households that have assets in the several (but not dozen) millions. They also represent one of the first and easiest level of theft employed by the high aristocracy, because of their foolproof protection of several million in assets. For now, though, we will focus on the minor aristocracy.
The bypass trust solves two problems. It 1) allows the surviving spouse to keep all the money, but 2) without having to pay taxes on the deceased spouse's half (or on their community property share, depending on the state where they died).
But how can this work? If the estate tax is imposed at death, how do Harry and Wilma get out of having it imposed when they die? The IRS has come up with complicated regulations that allow for the bypass trust to steal money from the rest of America, and keep it for the wealthy. Here's how it works:
Harry dies, owning $3 million. He uses his personal $2 million exemption to shield $2 of the $3 million from tax, and he gives that money to an imaginary person called a bypass trust. The remaining $1 million he gives to Wilma tax free, using the marital deduction. So, Wilma now has $4 million in her name.
Meanwhile, Mr. Bypass Trust owns $2 million. Strangely enough, Mr. Bypass Trust has to do whatever Wilma likes. If Mr. Bypass Trust makes any money off his investments, or has any other income at all, he has to give it all to Wilma. If Wilma needs money for her "health, education, maintenance and support" (shelter/mansion? clothes/prada? food/salmon? car/mercedes? anything in the world?), then Mr. Bypass Trust has to give Wilma any of the original $2 million she asks for. Also, Wilma manages all of Mr. Bypass Trust's bank accounts. She gets his statement and carries his checkbook. She signs the checkbook. She decides whether she needs any money for her health, her education, her maintenance or her support, and if she does, she writes herself a check.
Then, when Wilma dies, Mr. Bypass Trust can give the rest of the money to whoever he wants (whoever Harry decided he would give it to, when he died a few years ago) without paying any estate tax. Because, you see, Mr. Bypass Trust is a trust, not a real person. So, even though he can do all the things described above, he doesn't have to be responsible to the other taxpayers for little things like the estate tax.
Guess who gets the money from Mr. Bypass Trust when Wilma dies? That's right: little Joey, the same heir to Harry and Wilma that was going to get the money in the first place. However, since Joey was exempted from paying estate tax on the money owned by Mr. Bypass Trust, his tax bill is much lower. Let's figure it out.
With Mr. Bypass Trust, things look a lot better for them. Harry gives Wilma $1 million, and Mr. Bypass Trust $2 million. No tax due on any of it because of the marital deduction (for the $1 million to Wilma) and the estate tax exemption (for the $2 million to Mr. Bypass Trust). Then, when Wilma dies, we pretend she only has $4 million--not the $6 million she actually has if you are a person who doesn't believe in fairies or bypass trusts.
Thus, little Joey gets $2 million tax free from Mr. Bypass Trust. Wilma's $4 million death gift to him has a $2 million exemption, leaving only $2 million to be taxed, for a tax bill of $1 million. Little Joey pays $1 million and now has $5 million left. He (and Harry and Wilma's ghosts) have just stolen a million dollars from the rest of the country.
This theft only works if you believe in imaginary beings named Trust, who are allowed to hold property, but don't live, eat, breathe, work, or operate under the same rules. Because Trusts can be complicated to create, lawyers are able to charge between $2K-$10K for creating them. And as a result, every time a bypass trust is created and funded during 2008, the wealthy will steal over $400,000 from America (depending on the applicable tax rate). After 2009, when the exemption goes up to $3.5 million, the wealthy will begin funding bypass trusts with $3.5 million, thereby stealing about $1.5 million from the body politic each time (again, depending on the applicable estate tax rate).
Why does this work? Because of the fact that, as previously discussed, imposing tax burdens on "everyone," and then exempting only certain people in complicated ways, does not feel as much like theft to the victims. When the masses believe they are paying their fair (or reasonably fair; "everyone cheats a little!") share of taxes rather giving money to people with millions of dollars and bypass trusts, they are less likely to make trouble about it.
The rationalization that the mainstream uses to justify bypass trusts is that by giving the money to Mr. Bypass Trust, Harry did not really give the money to Wilma. They claim that because Wilma cannot do anything she wants with the money, what Harry was actually doing was giving the money to Little Joey, and just letting Wilma have some benefit until she died. This claim, though, is ridiculous: bypass trusts allow Wilma to do essentially whatever she wants with the money Mr. Bypass Trust owns. She controls it to such a degree that she could only really be penalized if she gave it all to a male prostitute, or the Prime Minister of Nigeria. The only reasonable thing she can't do is decide who gets it when she dies--what an awful loss (especially since she and her lawyer helped her husband decide who was going to get it when she died anyway, when they were in the lawyer's office planning how the bypass trust would work). This immense sacrifice on her part is the purported justification for taking money from everyone else.
The avowed purpose of the estate tax is to ensure that the immensely rich have their massive fortunes gradually broken down, so that the wealth can be spread around the economy for investment, economic growth, and the benefit of the body politic. The core idea is that any amount over $2 million (or whatever exemption amount) should be taxed before it can be passed on for continual hoarding: even when passed between individuals who happen to be economically united in two-person Judeo-Christian marriage. However, the bypass trust scheme allows the aristocracy to "bypass" the individual exemption amount, and double it for those (wealthy) people who pay a small fee to lawyers to draw up the plans for the trust.
Next up: step up in basis.