Bypass Trust (Credit Shelter Trust) 2026: How It Works, Who Still Needs One, and the Step-Up Basis Trade-Off

The bypass trust — also called the credit shelter trust, unified credit trust, AB trust, or family trust — was once the cornerstone of every HNW estate plan. Its purpose: ensure that both spouses' estate tax exemptions are used rather than letting the first spouse's exemption evaporate at death. Federal portability (introduced in 2011) let estates transfer the deceased spouse's unused exemption to the surviving spouse, raising the question: is the bypass trust obsolete? The short answer is no — but the calculus is more nuanced in 2026. GST exemption is not portable. Nine states and DC impose estate tax without state portability. Bypass trust assets grow outside the surviving spouse's estate. And portability requires a timely election that can be lost when the surviving spouse remarries. This guide explains when a bypass trust remains the better choice, when portability wins, and the step-up basis trade-off that determines the answer for your specific estate.

How a bypass trust works

A bypass trust is typically built into a couple's revocable living trust as a formula clause. At the first spouse's death, the trust splits into two shares:⁴

1. Bypass share (credit shelter share): Funded with assets up to the applicable exemption — $15M federally, or the state exemption amount in states with a lower threshold. The deceased spouse's exemption shelters this share from estate tax at the first death. The assets grow inside the trust and are never includable in the surviving spouse's taxable estate at the second death.
2. Marital share: Everything above the bypass share passes to the surviving spouse outright or into a QTIP trust under the unlimited marital deduction, deferring estate tax to the second death.

The surviving spouse typically receives all income generated by the bypass trust (interest, dividends, rent) and may receive principal distributions under a HEMS standard (health, education, maintenance, and support). At the surviving spouse's death, the bypass trust assets pass to heirs free of estate tax — because the deceased spouse's exemption already sheltered them at the first death.

Why the assets "bypass" the surviving spouse's estate

The trust is irrevocable at the first spouse's death. The surviving spouse is not the owner — they are a beneficiary. Because the surviving spouse does not own the bypass trust assets, those assets are not includable in the surviving spouse's gross estate under IRC §2033 at the second death. Any appreciation in the bypass trust between the first and second deaths also escapes estate tax. On a $3M bypass trust that grows to $5M over 12 years, that $2M of appreciation passes to heirs with no additional estate tax — it would have been taxed if the assets were held outright by the surviving spouse.

Five reasons bypass trusts still matter in 2026

1. GST exemption is not portable

The federal portability election transfers the deceased spouse's unused estate tax exemption — the DSUE — to the surviving spouse. It does not transfer the deceased spouse's unused generation-skipping transfer (GST) exemption.¹ If you want both spouses' $15M GST exemptions to shelter assets flowing to grandchildren or a dynasty trust, the only mechanism is a bypass trust (with a GST exemption allocation at the first death). Relying on portability for the estate tax exemption while expecting to also use both GST exemptions is not available.

2. Nine states and DC have no state portability

The following states and DC impose estate tax on their residents — and none offers portability of the state exemption between spouses. In each jurisdiction, a bypass trust funded at the first death uses both spouses' state exemptions rather than one:

State exemptions verified from each state's taxation authority as of 2026. Connecticut's $15M exemption mirrors the federal amount, making the bypass trust less urgent there at most estate sizes. Hawaii and Maryland are the only two state estate tax jurisdictions that offer portability of the state exemption.

A federal portability election cannot substitute for state portability that does not exist. On a $5M Massachusetts estate, using both spouses' $2M exemptions (via bypass trust) versus one (via portability) saves approximately $150,000 in MA estate tax. Residents of Oregon, Rhode Island, and Washington DC face even more acute exposure given their lower exemptions.

3. Portability can be lost

The DSUE follows the surviving spouse — but only from the most recently deceased spouse. If the surviving spouse remarries and the new spouse dies before them, the DSUE from the first marriage is permanently lost and replaced by whatever DSUE the second spouse leaves.² For surviving spouses who may remarry, the bypass trust is permanent: assets remain protected regardless of subsequent marriages.

Portability also requires a timely Form 706 election. Estates under the filing threshold have up to five years under Rev. Proc. 2022-32 — but the election must be made. If the executor misses the deadline, the DSUE is permanently forfeited.

4. Asset protection

Assets in a bypass trust are owned by the trust, not by the surviving spouse. They are protected from the surviving spouse's creditors, from claims arising from subsequent marriages, and in some states from Medicaid spend-down requirements. Assets held outright by the surviving spouse — including assets inherited via a portability election — carry no such protection.

5. Locking in the exemption against future law changes

OBBBA made the $15M exemption permanent. But for families who remember planning around the scheduled 2026 sunset, the lesson is clear: tax law changes. Assets funded into a bypass trust at the first death are permanently sheltered by the exemption in force at that time, regardless of future legislation. Portability merely transfers the DSUE — a future law change could eliminate portability prospectively, leaving the surviving spouse with only one exemption.

The step-up in basis trade-off — the main cost of a bypass trust

The primary cost of a bypass trust is the loss of a second step-up in basis. This trade-off is the central question in the bypass trust vs portability decision.

First death step-up: Assets transferred to the bypass trust receive a full step-up in basis to fair market value at the first spouse's death (IRC §1014).⁵ If the deceased spouse owned $2M of stock purchased for $200K, the bypass trust's basis is reset to $2M — the $1.8M of unrealized gain is permanently forgiven.

No second death step-up: When the surviving spouse later dies, bypass trust assets are not includable in the surviving spouse's gross estate, so they do not receive a second step-up under IRC §1014. If that $2M of stock has grown to $3.5M by the surviving spouse's death, heirs who sell it owe capital gains on the $1.5M of post-bypass appreciation — approximately $357,000 at the combined 23.8% federal long-term capital gains + NIIT rate.

Portability preserves the second step-up: If the surviving spouse inherits the same stock outright with a portability election, the stock gets a full step-up to $3.5M at the surviving spouse's death. Heirs sell with zero capital gains. The portability trade-off: the assets remain in the surviving spouse's estate (offset by the DSUE). Use our Step-Up Basis Calculator to model the hold-vs-gift trade-off for your specific assets and estate.

When bypass trust wins vs when portability wins

Bypass trust vs QTIP trust: when to use each — and both

On large estates, the bypass trust and QTIP trust are typically used together rather than as alternatives:

• Bypass trust: Absorbs assets up to the applicable exemption ($15M federal, or the lower state exemption). No estate tax at the first death. Assets grow permanently outside the surviving spouse's estate with no step-up at the second death.
• QTIP trust: Absorbs the remainder above the exemption under the unlimited marital deduction — deferring estate tax to the surviving spouse's death. QTIP assets are included in the surviving spouse's estate and receive a full step-up in basis at the second death. The first spouse to die controls who ultimately inherits.

For a $20M estate: bypass trust absorbs $15M (federal exemption), QTIP trust absorbs the remaining $5M under the marital deduction. At the surviving spouse's death: $5M in QTIP trust is included in the estate (step-up applies), bypass trust assets pass to heirs with no estate tax. The combination minimizes estate tax at both deaths while preserving the step-up basis on the QTIP assets. See the full QTIP Trust Guide for blended-family applications and worked examples.

A critical warning: formula clause review after OBBBA

Many estate plans drafted before July 2025 include bypass trust formula clauses that fund the bypass share with the "applicable exclusion amount" — meaning the full federal exemption in force at death. Before OBBBA, with a $7M expected 2026 exemption, that was intentional. Now that the exemption is $15M permanent, an unrevised "applicable exclusion amount" formula could pour-over the entire estate into the bypass trust at the first death — potentially disinheriting the surviving spouse and triggering inadvertent consequences.

If your estate plan was drafted before July 2025 and contains a formula clause tied to the applicable exclusion amount or "greatest amount that can pass free of estate tax," have it reviewed by your attorney immediately. The correct approach for most estates today: cap the bypass trust at the state exemption (for state estate tax planning) or at a specific dollar amount, with the balance to the QTIP or marital share.

How to set up a bypass trust: the steps

1. Draft the revocable trust with bypass and marital share provisions. Your estate planning attorney drafts a formula clause that splits the trust at the first death. This is done now — while both spouses are alive — not after the first death.
2. Equalize assets between spouses. The bypass trust can only be funded with assets in the deceased spouse's name. If one spouse owns everything, the trust can't be funded. Work with a financial advisor to retitle assets so both spouses have enough in their own name to fund their respective bypass shares.
3. Fund the trust at the first death. When the first spouse dies, the successor trustee (often the surviving spouse) must actually segregate and transfer assets into the bypass trust sub-account. This is where many plans fail: the legal structure is correct but no one takes action to divide the assets into bypass and marital shares.
4. File Form 706 if applicable. Even if no federal estate tax is owed (estate under $15M), Form 706 must be filed to elect portability. Rev. Proc. 2022-32 allows up to five years for late portability elections on non-filing estates — so even if you choose a bypass trust, filing Form 706 preserves the DSUE as a backstop.
5. File Form 1041 annually. The bypass trust is a separate taxpayer for income tax purposes. Any income (interest, dividends, rent) retained in the trust — rather than distributed to the surviving spouse — is taxed at compressed trust income tax rates. Most planners distribute income to the surviving spouse to use their lower individual bracket.

Case study: the Chen family in Massachusetts

Situation: David (67) and Linda Chen (63) in Lexington, MA. Combined estate: primary home $1.4M (joint), investment portfolio $2.8M (David's revocable trust), Linda's brokerage $800K, David's IRA $600K. Combined net worth: $5.6M. No bypass trust provision in their current revocable trust. Massachusetts estate tax exemption: $2M per person, no portability, 0.8%–16% graduated rates.

Without bypass trust (portability only — irrelevant for MA):

• David dies first. Everything passes to Linda via marital deduction. MA estate tax at first death: $0. David's $2M MA exemption is permanently lost.
• Linda dies 12 years later with a $7M estate (original $5.6M, less IRA distributions, plus growth). MA estate tax on $7M with only Linda's $2M exemption: approximately $560,000. Federal estate tax: $0.
• Net to heirs: $7M − $560,000 = $6,440,000.

With bypass trust + annual gifting:

• David dies first. $2M from his investment portfolio funds the bypass trust. Remaining $3.6M + $600K IRA passes to Linda via marital deduction. MA estate tax at first death: $0.
• Linda gifts $38,000/year ($19K per recipient × 2 adult children) = $456,000 removed from estate over 12 years, plus appreciation on those gifts.
• Linda dies 12 years later with approximately $5.2M in her own name. Bypass trust holds $2M grown to $3.1M (assuming 3.5% real growth net of distributions). MA estate tax on $5.2M with Linda's $2M exemption: approximately $288,000. Bypass trust: $0 MA estate tax (sheltered at David's death).
• Net to heirs: $5.2M + $3.1M − $288,000 = $8,012,000.
• Benefit vs no-planning scenario: $8,012,000 vs $6,440,000 — $1,572,000 more to heirs. The bypass trust alone accounts for approximately $272,000 of that savings (the MA estate tax difference); the remainder reflects the appreciation in the bypass trust ($1.1M) and annual gifts ($456K + growth) that escape Linda's estate.

Working with a fee-only advisor on bypass trust planning

The bypass trust vs portability decision requires analyzing your state of residency, asset types and their current cost basis, expected rates of return, the surviving spouse's health and longevity, and whether you have GST planning goals. A fee-only financial advisor — one who charges a flat fee or percentage of assets rather than earning commissions — can model both scenarios with your actual numbers and coordinate the analysis with your estate attorney's document drafting. The advisor's role is not to replace the attorney but to ensure the financial assumptions behind the plan are sound before the attorney drafts the formula clauses.

For families in Massachusetts, Oregon, Washington, Rhode Island, New York, and other no-portability states, the bypass trust math is straightforward enough that the analysis should happen before either spouse turns 70. Asset equalization — rebalancing whose name assets are in — takes time and sometimes involves income tax implications that need to be sequenced carefully.