Exemption Trusts: A Method of
Reducing Federal Estate Taxes

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.

HOW DOES IT WORK? Let's look at how the estate of a married couple would be taxed during 2009 if the couple did not have an exemption trust: (The federal estate tax is currently in limbo because Congress has not acted on a pending bill that would continue the $3.5 million exemption. If the bill is passed, the following discussion will be relevant.)

EXAMPLE 1:

Assume that a married couple owns $7,000,000 in community property and the couple has no estate plan. On the death of the first spouse, 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 a "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 $7,000,000 estate, but there is only one $3,500,000 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 2009 with an estate of $7,000,000, a tax of about $1,500,000 will be due from his or her estate.

EXAMPLE 2:

Assume that a married couple with a net worth of $7,000,000 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, $3,500,000, 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 $1,500,000. 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.

This website is organized and written by the Law Office of Stephen C. Gruber, 5050 El Camino Real, Suite 111, Los Altos, California 94022.

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Exemption Trusts: A Method of Reducing Federal Estate Taxes

Exemption Trusts: A Method of
Reducing Federal Estate Taxes