WHAT IS AN EXEMPTION TRUST? An exemption trust is known by many names, including bypass trust, credit shelter trust, or B trust.
Regardless of the name of the trust, its purpose is to reduce or eliminate federal estate taxes for a married couple's estate. This type of estate plan sets up an irrevocable trust that will hold the assets of the first spouse to die. The amount transferred to the irrevocable trust usually will not be taxed for federal estate tax purposes when the second spouse dies.
WHY SHOULD YOU USE AN EXEMPTION TRUST? If your estate is greater than $5.49 million, and you are married, an exemption trust could reduce the tax liability of your estate, or eliminate it entirely.
HOW DOES IT WORK? Let's look at how the
estate of a married couple would be taxed if the couple did not have an
exemption trust and the exclusion amount is $5.49 million in 2016:
Assume that a married couple owns $10 million in community property and the couple has no estate plan. On the death of the first spouse in 2017, that spouse's assets will be transferred to the surviving spouse in accordance with the intestate succession laws. Regardless of the amount that is transferred, there will be no federal estate tax imposed at this point. Federal law allows the "marital deduction" to be used when assets are transferred to the surviving spouse, and that deduction eliminates any tax that might otherwise be due. However, it also eliminates use of the exemption for the first spouse to die because he or she had no estate remaining that can be exempted from the tax.
As a result of the death of the first spouse, the surviving spouse now owns the entire $10 million estate, but there is only one $5.49 million exemption available because the marital deduction was used to transfer the entire estate of the first spouse to the surviving spouse. If the surviving spouse dies during 2017 with an estate of $10 million, a tax of about $1.8 million will be due from his or her estate if portability cannot be used.
Assume that a married couple with a net worth of $10 million has set up a living trust that includes an exemption trust. While both of them are alive, the assets will be held in the revocable living trust. On the death of either one of them, the trust will be split into two trusts: The survivor's trust, and the exemption trust.
In this example, the deceased spouse's share of the estate, $5 million, will be transferred to the exemption trust. The "marital deduction" will not be used because there are no assets that are transferred to the surviving spouse. (The exemption trust and the surviving spouse are two separate taxpayers for this purpose, even though the surviving spouse will receive the income from the exemption trust and may spend the principal of the trust in certain limited circumstances.) As a result, the exemption amount for the first spouse to die is not lost because his or her assets were transferred to a taxpayer other than the surviving spouse. Although this may seem like a minor difference in the estate plan, establishing the irrevocable trust will save the couple's estate approximately $1.8 million. If the surviving spouse dies with an estate that is not valued at more than the exemption amount that is allowed in the year of death, the surviving spouse's estate will pay no federal estate tax.
OTHER OPTIONS TO AVOID THE ESTATE TAX: A disclaimer trust can also be used instead of an exemption trust. The surviving spouse can decide whether to exercise his or her disclaimer rights, which will reduce the amount of the estate subject to the estate tax. For more information about avoiding the federal estate tax, see the portability page.