Terminating a Bypass Trust in California: What You Need to Know
Modern Estate Planning Strategies for Outdated Trust Structures
Many people who created AB or ABC Trusts in the past may now find that their estate plan no longer aligns with today’s tax laws. These trusts—especially the Bypass Trust portion—were once critical tools for minimizing estate taxes. Thanks to significant changes in federal tax law and the introduction of portability, keeping a bypass trust in place may actually create unnecessary tax liabilities.
In this article, we explain why you might want to consider terminating a bypass trust, how the step-up in basis works, and the options available to help you simplify your estate plan and reduce capital gains exposure.
Key Takeaways
- Bypass Trusts no longer make sense for many families due to high estate tax exemptions and portability.
- Bypass trusts can result in significant capital gains tax exposure without a step-up in basis.
- California offers a path for terminating a Bypass Trust.
- Always consult with a qualified California estate planning attorney to assess your options and protect your heirs.
What Is a Bypass Trust?
A Bypass Trust (often referred to as the “B” Trust, Credit Shelter Trust or Exemption Trust) is formed when the first spouse in a marriage dies. His or her half of the community property—and any separate property—is transferred into the Bypass Trust, which is irrevocable. Meanwhile, the surviving spouse’s share remains in the Survivor’s Trust and is amendable during his or her lifetime.
The original purpose of the Bypass Trust was to “bypass” estate taxes by freezing the deceased spouse’s assets and removing them from the surviving spouse’s taxable estate.
Why Bypass Trusts Often No Longer Make Sense
Today, most families won’t owe any federal estate tax because of the significantly increased exemption. In 2025, each person can pass $13.99 million ($27.98 million per couple) free of estate tax—making bypass trusts obsolete for the majority of Americans. Under the One Big Beautiful Bill Act, the exemption increases to $15 million starting 2026.
Moreover, when the surviving spouse dies, the assets in the Survivor’s Trust receive a step-up in basis, eliminating capital gains for his or her heirs. By contrast, assets in the Bypass Trust do not receive this step-up, potentially leaving children or other beneficiaries with a hefty capital gains tax bill.
Example:
John and Jane created an AB trust in 2005. John died in 2012 when John and Jane had $2 million. John’s $1 million share (his ½ of the community property and any separate property) was placed into a Bypass Trust. Jane’s $1 million share was allocated to the Survivor’s Trust. Over the next 13 years, the Bypass Trust’s assets grew to $5 million and the Survivor’s Trust assets grew to $5 million. Upon Jane’s death, their children will inherit:
- Jane’s $5 million in the Survivor’s Trust: step-up in basis to $5 million, no capital gains tax.
- John’s $5 million in the Bypass Trust: $4 million in taxable gains (roughly $1.4 million in combined California and federal capital gains taxes).
If instead, all $10 million of assets were held in Jane’s Survivor’s Trust, their children would have inherited:
- Jane’s $10 million in the Survivor’s Trust: step-up in basis to $10 million, no capital gains tax.
- Because Jane’s total estate was $10 million when the estate tax exemption was $13.99 million, no estate taxes. Even if Jane’s estate was greater than the estate tax exemption, she could have used portability to transfer John’s unused estate tax exemption of $5 million.
Can You Terminate or Close a Bypass Trust in California?
Yes—California law offers several pathways for terminating or modifying an irrevocable trust, including a Bypass Trust, particularly when tax planning goals have changed or become irrelevant.
- Court Petition – Probate Code §15409 – Change in Circumstances
Under California Probate Code §15409, a Bypass Trust can be modified or eliminated due to a change in tax laws.
Best for: Families with good relationships and shared goals.
Caution: All current and future (contingent) beneficiaries should consent. This may include grandchildren or others named in the trust. This can be difficult with minor beneficiaries.
- Distributing the Bypass Trust to the Survivor’s Trust
If the Bypass Trust allows the trustee (usually the surviving spouse) to make discretionary distributions, they may be able to distribute all assets to the Survivor’s Trust—effectively eliminating the Bypass Trust.
Important: Doing this usually requires:
- Written consent of the adult children (if they are remainder beneficiaries), and/or
- Court approval to minimize risk of later disputes.
Once the assets are moved into the Survivor’s Trust, they will be eligible for a step-up in basis at the survivor’s death.
Why You Should Revisit Your Trust Now
Many AB or ABC Trusts created before 2011 haven’t been reviewed since the law changed. Continuing to maintain an outdated Bypass Trust can result in:
- Unnecessary tax filings (Form 1041 for the Bypass Trust),
- Large capital gains liabilities for children, and
- Complicated trust administration and beneficiary confusion.
If your estate is well below the federal estate tax exemption and you share the same heirs with your spouse, keeping the Bypass Trust may offer no estate tax benefit while triggering significant capital gains tax issues.
Ready to Review or Terminate a Bypass Trust in California?
If you or a loved one are managing a Bypass Trust created years ago and want to explore modern alternatives, our experienced estate planning attorneys can help. We’ll walk you through the pros and cons of trust termination and handle the legal process to ensure your estate plan works for today—not 20 years ago.
Contact us today to schedule a trust review and discover how you may be able to simplify your plan and save your heirs potentially millions in taxes.
John Wong advises on all aspects of estate planning, probate, asset protection and trust administration. He believes that estate planning is about planning for life; while having protections in place should the unexpected occur.
