The combination of individual applicable exclusion amounts and the unlimited marital deduction can create a trap for the unwary. If all of the couple’s wealth is transferred to the surviving spouse on the first death of a husband and wife, there will not be an estate tax due at that point because of the unlimited marital deduction. However, the applicable exclusion amount of the first spouse will have been wasted as all of the couple’s wealth will be included in the second spouse’s taxable estate and will be sheltered only by the individual applicable exclusion amount of the second spouse.
How Does it Work?
This can be a costly mistake. As an example, assume that a husband and wife each own $2,000,000 of property. On the husband’s death, he leaves all $2,000,000 directly to his wife. There will be no estate tax liability on the husband’s death. However, the wife now has a taxable estate of $4,000,000, and upon her death, she will be only able to shelter $2,000,000 of the $4,000,000 of property from estate tax. This leaves an estate tax due on her death of $900,000 (45% times $2,000,000).
A credit shelter or bypass trust is designed to hold property in value equal to the applicable exclusion amount of the first spouse to die, keeping this property outside of the surviving spouse’s taxable estate and free from estate taxes on the second death. By utilizing a bypass trust on the first death, a couple can double-up and use both of their individual applicable exclusion amounts to avoid estate taxes. This technique is usually one of the first steps in planning for minimizing transfer taxes.
How is it Designed?
The bypass trust can be designed so that the surviving spouse is designated as the trustee to control how the property in the bypass trust will be invested. The surviving spouse can also be included as a beneficiary of trust income and principal if these distributions are subject to an ascertainable standard such as health, maintenance, education, and support.
A bypass trust can either be funded with a set amount (typically according to a formula that will maximize the available exclusion amount on the first death) or, as the applicable exclusion amounts have increased, it is becoming more commonplace for the bypass trust to be funded by a disclaimer by the surviving spouse. A surviving spouse has nine months following the date of their spouse’s death to disclaim property that they would otherwise inherit. The use of a disclaimer in funding the bypass trust allows for more flexibility when determining how much property must be transferred to the bypass trust and even whether the bypass trust should be funded at all.
With the applicable exclusion amount set to increase to $3,500,000 on January 1, 2009, a couple that properly utilizes both of their applicable exclusion amounts should be able to pass up to $7,000,000 of property to their descendants free from estate taxes.