Making Maximum Use of the Spousal Exemption

The best provision of federal estate tax law from the taxpayer’s perspective is the unified credit, which gives each person an exemption from estate taxation, currently $2 million and increasing to $3.5 million in 2009). But what do you do if your wealth exceeds that amount?

One of the most basic tax-planning devices is the unlimited marital deduction. It allows one spouse to pass his or her entire estate, regardless of size, to the other--and not pay federal estate taxes. No matter how large the estate, no taxes are due where it is passed to the spouse.

If you only cared about leaving your property to your spouse, that would end your tax worries. Most people, however, want to leave property to their families at the death of the second spouse--and this is where tax planning pays off.

To take full advantage of the unified credit and the unlimited marital deduction, taxpayers with assets above the exemption amount will probably be advised to use a trust. This is especially important for married taxpayers. Trusts are one of the main ways to minimize taxes upon death.

Using the marital deduction properly, usually in conjunction with a tax-saving trust (as explained below), you should be able to transfer at least double the exemption amount free of estate taxes to your children or other beneficiaries no matter which spouse dies first or who accumulated the wealth.

• Bypass trusts

  One of the most common of these is the credit shelter trust, also called the exemption trust or bypass trust. It’s called a bypass trust because the entire unified credit (exemption amount) bypasses the surviving spouse’s taxable estate, for tax purposes, and goes directly to a trust that ultimately benefits the children, grandchildren, or other beneficiaries when the second spouse dies. The surviving spouse can be an income beneficiary of this trust too.

  Here’s how it works. Assume that in 2005 when the exemption was $1.5 million, Johnny died, survived by his wife, Frankie, and several children. The adjusted gross estate (his estate after deducting funeral expenses, expenses of administration, and claims) totalled $3 million. Johnny’s will (or trust) either created a marital trust (see below) or provided for a direct distribution of $1.5 million for his wife; the remaining $1.5 million was put into a bypass trust. If the will created a marital trust, the income from the trusts must be payable to her for as long as she lives. On her death, her estate and the trusts can pass to the children free of federal estate taxes.

  When Johnny dies, his estate will not owe estate taxes. The $1.5 million marital trust or direct distribution to Frankie was not taxed because of the unlimited marital deduction. The distribution to the bypass trust used his 2005 $1.5 million exemption so there was no federal estate tax at Johnny’s death.

  During her lifetime, Frankie will be able to maintain her lifestyle, since she can benefit from all of the assets from Johnny’s estate. Proper planning can enable people to reduce their tax liability without adversely affecting their lifestyles or those of their loved ones.

  There may also be no federal estate tax at Frankie’s death. The property in the bypass trust will pass to the children. Again this trust is free of estate tax. The key question is the size of Frankie’s estate upon death. The distribution from Johnny’s estate was added to Frankie’s taxable estate. If at her death her estate is now larger than the available exemption, she may owe taxes, but far less than if she had inherited all of Johnny’s estate outright. If her estate is not larger than the available exemption amount, no federal estate taxes will be due as the result of her death.

  What if a Bypass Trust Won’t Be Enough?

  For estates beyond the double exemption amount, there are other tools that estate planners use to limit taxes, such as removing the value of life insurance from the estates and gifting. Both of these are discussed in the next chapter.

• Marital Trusts

  We mentioned marital trusts in the previous section. They are used to enable the decedent spouse take full advantage of the unlimited marital deduction while enabling him or her to control the disposition of the property during the life and after the death of the surviving spouse. The advantage of using such a trust, as opposed to a direct gift in the will, is precisely that the trustee of the trust can make distributions from the trust over a period of time, can make annual distributions, etc.—all the money does not have to pass at one time, with no guidance as to how the money is used.

  Special rules apply to qualify for the marital trust if the spouse is not a U.S. citizen. Check with your lawyer.

  There are two commonly used marital trusts.

  • Power of appointment trust

    This is structured so that one spouse gives a trustee property to be held for the benefit of the other spouse, providing the other spouse with the use of the principal and all the income. At the death of the first spouse to die, the surviving spouse receives a general power of appointment that permits her to determine where the property should go after her death--to the children, charity, other beneficiaries, etc. Like all trusts, it avoids probate. It will generally qualify for the marital deduction and thus escape taxation at the first spouse’s death. The only potential problem (for some people) with a power of appointment trust is that it gives your surviving spouse total discretion over what happens to your money after you die.

  • QTIP trusts—for heirs, not ears

    People who are afraid of giving up so much control to the spouse often turn to the second principal marital trust. A qualified terminable interest property--QTIP--trust is a marital trust that doesn’t grant the spouse a general power of appointment. It’s especially favored for people who want to make sure their children aren’t slighted if their surviving spouse remarries or has her own children or other beneficiaries whom she prefers.

• Other Trusts

  There are many other tax-saving trusts, among them generation-skipping trusts (sometimes known as wealth trusts or dynasty trusts). Trusts generally benefit your children, but you can keep saving taxes and provide for your descendants for several generations after your death by using a generation-skipping trust. Such a trust is quite versatile, allowing your family to use the money for college costs, medical expenses, large purchases such as homes, and general support. And it avoids or limits estate taxes on the estates of your children. You’ll probably want include your children as discretionary beneficiaries, as well as more remote generations.

  In a generation-skipping trust, instead of distributing all the money in the trust to beneficiaries upon your death, you can use your federal exemption to leave the available amount to future generations. This way, you can keep at least some of your assets out of the control of children who might squander it or lose it in a divorce. If you put more than the tax-exempt amount in a generation-skipping trust, it may be subject to taxation, either immediately (if no person in your child’s generation is a beneficiary) or at a later time, but it can grow tax-free beyond the exemption amount through investments and interest.

  As with all tax-saving trusts, be sure to consult a lawyer here, because there is a generation-skipping tax that may apply.

  Insurance trusts are also common, as a way of assuring that taxes don’t have to be paid on the benefits of the policy. We discuss these in the next chapter.

Handy in Several Ways

Not only can irrevocable trusts be used to reduce taxes on an estate, they can also help pay taxes that are incurred. For example, the cash assets in the irrevocable trust can be used to buy assets from the estate, providing the estate with cash to pay taxes.