What to Do When a Bypass Trust Was Never Funded

Summary

---

Podcast Summary: What to Do When a Bypass Trust Was Never Funded

ACTEC Trust & Estate Talk
Host: Margaret Van Houten (ACTEC Fellow)
Guest: Mickey Davis (ACTEC Fellow, Houston, Texas)
Date: July 14, 2026

---

Episode Overview

This episode addresses a common but troublesome scenario faced by estate planners: a bypass trust (also known as a credit shelter trust) created upon the death of the first spouse is never actually funded. Margaret Van Houten introduces the topic and invites Mickey Davis to explore practical and legal remedies for reconstructing or retroactively funding an unfunded bypass trust, often many years later. The conversation unpacks state law strategies, relevant case law, implications for estate tax, cost basis, and the critical nature of reporting requirements.

---

Key Discussion Points & Insights

Prevalence and Core Issue

• Bypass trusts are frequently not funded after the death of the first spouse—an issue faced by nearly all practitioners.
• The consequences can be serious, affecting estate taxes and the intended disposition of assets.
  • Quote ([00:55], Mickey Davis):
    "Is there any way for us to fix this broken bypass trust? ... There are several tools that can be brought to bear to fix this bad situation."

State Law Theories for Reconstructing the Trust

• Federal estate tax rules reference state law to determine property rights, so local remedies are vital.
• Key question: Can assets that should have gone into the bypass trust be treated, for tax and administration, as if they had been?

Case Law Examples

1. Richard v. Commissioner
   • Scenario: Mom’s bypass trust wasn’t funded; years later, shares are claimed for the trust.
   • Outcome: Court ruled the assets vested in the bypass trust at death—they were never the surviving spouse’s.
   • Impact: Assets excluded from surviving spouse’s estate for tax.
   • Quote ([02:45], Mickey Davis):
     "The taxpayers were successful in prevailing on the theory that mom's assets vested in the bypass trust at the moment of her death, they never belonged to dad and therefore they're not included in dad's estate."
2. Stansberry Case (not bypass-specific)
   • Scenario: Assets wrongly taken and retitled; court imposes a constructive trust.
   • Principle: Even if assets are mixed, if it’s impossible to sort them out, courts may presume all belong to the wronged party (here, the trust).
   • Quote ([04:26], Mickey Davis):
     "If it's hopelessly commingled and we can't sort it out, the presumption is that all of the assets belong to the bypass trust."
3. Bailey Case (Texas)
   • Scenario: Son’s inheritance retitled by mother.
   • Outcome: Son could deduct from mother’s estate the assets’ value he should have received.
   • Quote ([05:10], Mickey Davis):
     "You're entitled to deduct from mom's estate the value of the money she effectively stole from you."

---

Remedial Theories: Exclusion vs. Debt Approach

• Exclusion Approach
  • Treat assets as never belonging to the surviving spouse—potentially below estate tax threshold, but no basis step-up.
  • Reporting: Possibly no estate tax return required.
• Debt/Deduction Approach
  • Treat the surviving spouse’s estate as “owing” the trust; all assets included in the estate, but a deduction is claimed.
  • Assets get a basis adjustment, but estate must file a tax return and properly document/pay the claim.
  • Quote ([05:30], Mickey Davis):
    "If instead we use the debt approach ... all the assets in mom's estate are going to get a basis adjustment. We may have to file an estate tax return, but we're going to take a big deduction that makes the tax go away."

---

IRS and Timing Considerations

• Regulatory Changes
  • IRC § 2053: To claim a debt deduction against the estate, the claim must not only be valid but also paid (or a protective election made).
  • Statute of Limitations: May only begin once beneficiaries know—or should have known—something was wrong, making late claims sometimes possible.
  • Quote ([06:48], Mickey Davis):
    "Beneficiaries get to presume that an executor is going to fulfill his duties until he affirmatively renounces them."
• Procedural Pitfalls
  • Failing to properly file a claim in probate can bar the deduction, as in the referenced unreported Ohio case.
  • Quote ([08:23], Mickey Davis): "They did all the things that executors did and and then they decided to make a claim ... but the period for you making the claim has run. And so, so sad. Too bad we're not going to let you take that deduction."

---

Notable Quotes & Memorable Moments

• "There is no one size fits all approach. The route you choose can have a dramatic difference on reporting requirements, cost basis, and other aspects of estate and trust administration."
  — Margaret Van Houten ([00:35])

• "When—not if—this problem comes upon your desk, here are some good ideas for you to think about and ways to go back and reconstruct these trusts."
  — Mickey Davis ([09:30])

• On IRS Scrutiny:
  "Will the IRS come back and turn some of these against us and say, oh, you don't get a basis adjustment, we're going to use these theories to deem the bypass trust as funded? Well, we'll see how that all plays out."
  — Mickey Davis ([08:57])

---

Timestamps for Important Segments

• 00:39 — Margaret introduces the bypass trust funding problem and Mickey’s background.
• 01:37 — Mickey sets up practical scenarios estate planners often face.
• 02:35 — Discussion of Richard v. Commissioner and critical state law principles.
• 04:26 — Commingled assets and constructive trust concept (Stansberry case).
• 05:10 — Debt/deduction approach explained (Bailey case).
• 06:48 — Statute of limitations and beneficiary rights.
• 08:23 — Procedural warning from the unreported Ohio case.
• 08:57 — Discussion of potential IRS positions and future uncertainties.
• 09:30 — Final advice and resources mentioned.

---

Practical Takeaways

• Analyze facts carefully: There are multiple theories for retroactively funding a bypass trust—each with trade-offs.
• Leverage state law: Rights and remedies are often determined under local law, not just tax law.
• Document and file claims properly: Failing to notice a probate court within required time can forfeit tax deductions.
• IRS rules and reporting: Be aware of changes in deduction rules and reporting requirements—consult latest regulations.
• Expect these scenarios: Practical wisdom from the episode: virtually all practitioners will face unfunded bypass trust problems.

---

For case citations and more references, consult the episode transcript.

---

Transcript

[A]

What to do when a bypass trust was never funded? That is the subject of today's ACTEC Trust and Estate Talk.

[B]

Welcome to ACTEC Trust and Estate Talk from the American College of Trust and Estate Council, a professional society of peer elected trust and estate lawyers in the United States and around the globe. This series offers professionals best practice advice, insights and commentary on subjects that affect our profession and clients. And now our ACTECH Fellow host with today's topic.

[A]

This is ACTEC Fellow Margaret Van Houten of West Des Moines, Iowa. At a recent ACTEC meeting, Fellow Mickey Davis of Houston, Texas, asked how many attendees have not encountered the situation with where a bypass trust created when one's spouse dies was never funded? Almost no one raised their hands. Is there a way to fix this common problem by reconstructing an unfunded bypass trust long after the death of the first spouse to die or even after the death of the surviving spouse? Mickey will discuss a number of theories that can be used to put the pieces back together. There is no one size fits all approach. And Mickey reminds us that the route you choose can have a dramatic difference on reporting requirements, cost basis, and other aspects of estate and trust administration. Welcome, Mickey.

[C]

Thanks, Margaret. I appreciate it. So here's the scenario we seem to encounter more frequently. Hugh dies. His kids come to your office and they say, well, Dad's estate is $20 million and you asked for a copy of Wilma's will. Wilma was his spouse and she died several years ago. Well, her will created a bypass trust for dad. And you ask the kids about the bypass trust and they give you a blank stare. They say, what bypass trust? Dad told us everything belonged to him and he just took it all. Well, gosh, you go do some math. You realize Wilma's bypass trust should have gotten about $6 million and if that had happened, we wouldn't owe any estate tax in Dad's estate. Well, darn it, dad, he just didn't get his act together and get things funded. Is there any way for us to fix this broken bypass trust? And the answer is, although there's not a lot of great case authority out there, we think that there are several tools that can be brought to bear to fix this bad situation. Remember that the federal estate tax rules are governed by the Internal Revenue Code, but the estate tax is imposed upon the rights of a decedent, measured under state law. And so what we're looking for here are some state law remedies that let us put the bypass trust back together again. Well, what are those state Law remedies. And there are a variety of them out there that might be utilized. There's a case out there called Richard versus Commissioner where the kids encountered this very situation. Dad died, Mom's bypass trust was never funded. And their shares that were included in mom's estate, which the kids valued at $140,000, the IRS said, well, actually we think they're worth $27 million. Well, during the course of this administration, the kids found mom's will, had it admitted to probate, and said those shares belong to the bypass trust, not to dad's estate. And the taxpayers were successful in prevailing on the theory that mom's assets vested in the bypass trust at the moment of her death, they never belonged to dad and therefore they're not included in dad's estate. There's another great case out there called Stansberry. It's not a bypass trust case, but the husband talked his sister into giving him both halves of their inheritance. He had some creditor problems and so he transferred all those assets to his wife and then his wife died. Well, the sister sues the wife's estate and says, my brother tricked me out of those assets. They didn't belong to him. They certainly don't belong to you. And a court agreed with her. Now, the executors of, of the wife's estate say, wait a minute, we know we had all these assets titled in our decedent's name, but they really didn't belong to her. They were held in a constructive trust for sister in law and therefore should be excluded from the wife's estate. And the tax court, actually the Northern District of Illinois, approved that finding and allowed the assets to be excluded. If the husband, and my hypothetical at the beginning had taken all the assets and retitled them in his name, what are we to do? You know, he spent some of those dollars he added to it. They're all mixed up. Well, if Hugh is the trustee of that trust, he's probably breached a fiduciary duty. And in that case, the courts say that we can trace the assets. If Hugh was spending money, the presumption is he was spending his own money first. If it's hopelessly commingled and we can't sort it out, the presumption is that all of the assets belong to the bypass trust. So here we have these state law theories that allow us to reconstruct it. One other case I'll mention is the Bailey case. It's a Texas case. Again, not a bypass trust case. Mom retitled all of her son's inheritance in her name died many years later. The son found out what happened, and he filed a claim against Mom's estate. He said, my mom stole this money from me, and we're going to include all the assets in her estate, but we're going to take a deduction of what the current value of those assets would have been if I had received them back when I was little. And the court said, you're exactly right. You're entitled to deduct from mom's estate the. The value of the money she effectively stole from you. So think about some interesting issues here. If the assets are excluded in our example, that means we don't file an estate tax return because my client's estate is below the filing threshold. It also means those assets don't get a basis adjustment because they aren't included in the second decedent's estate. If instead we use the debt approach and we say, oh, yeah, mom made off with all these dollars, but I've got, she owes us the debt, she owes us the money. Now all the assets in mom's estate are going to get a basis adjustment. We may have to file an estate tax return, but we're going to take a big deduction that makes the tax go away. Now, many of these cases were out there before the IRS came in and changed the rules on how you deduct claims under code section 2053. You know, you've got to establish the claim and pay it before the estate tax return, or at least you've got to file some sort of protective election and make sure that the claim is paid in due course and then deducted. So if you're going to use the debt approach, then you're going to have to think about the 21st 53 regulations and how you document that. One of the issues is, has the statute of limitations run? Is it too late for you to bring this claim? Well, there's some pretty good case law out there. If dad took the money and he never really told the kids anything, there's some old case law out there that says beneficiaries get to presume that an executor is going to fulfill his duties until he affirmatively renounces them. So if dad never came to the kids and said, hey, by the way, I'm keeping all these assets, the statute of limitations might not even have started to run until the kids learn that the bypass trust was never funded. Watch out, though. There's an unreported case out of Ohio where the kids were administering Dad's estate. They sent out a notice to creditors. They did all the things that executors did and and then they decided to make a claim against Dad's estate for the unfunded bypass trust. Unfortunately, they never actually filed their claim with the probate court. And the court said, well, you might have had a claim, but the period for you making the claim has run. And so, so sad. Too bad we're not going to let you take that deduction. Well, as you can see, there are a lot of nuances and different theories that allow you to reconstruct the bypass trust. Curious now where clients are sort of not wanting to fund the bypass trust. Will the IRS come back and turn some of these against us and say, oh, you don't get a basis adjustment, we're going to use these theories to deem the bypass trust as funded? Well, we'll see how that all plays out. The citations to some of the cases I mentioned are going to be available to you in the transcript. I encourage you to take a look at that. And when I'm not going to say if, I'm going to say when this problem clear comes upon your desk, here are some good ideas for you to think about and ways to go back and reconstruct these trusts. Thanks a lot.

[A]

Thank you, Mickey, for this very informative explanation.

[B]

Thank you for listening to this episode of ACTEC Trust and Estate Talk, the podcast series about wealth planning matters from the American College of Trust and Estate Council. To find an ACTEC lawyer next near you, visit actec.org Please subscribe to this series and leave us a rating or a review.