What it means
Many countries tax large estates when a person dies, but allow a certain amount to pass tax free. In the United States, for example, each person has an exemption amount that is set by law and can change.
Assets left to a spouse generally pass tax free, which can lead to a problem: if everything goes to the survivor, the first spouse's exemption may be wasted. An exemption trust solves this.
On the first death, assets up to the exemption amount go into the trust instead of to the surviving spouse directly. The survivor can usually receive income from the trust and, under certain conditions, access to the capital for health, education, maintenance and support.
When the survivor dies, the trust assets pass to the children or other beneficiaries without being added to the survivor's estate. The growth in the trust after the first death also escapes estate tax.
That can be valuable if the assets, such as a business or a property, rise in value over time. The structure is also known as a credit shelter trust, bypass trust or family trust.
It is set up in the will or in a living trust document and is often combined with a marital trust for assets above the exemption amount. A trustee, who might be a family member, a bank or a professional adviser, manages the assets.
Rules have changed over time. In some countries, a surviving spouse can now claim the unused part of the first spouse's allowance, which reduces the need for this kind of trust.
Even so, an exemption trust can still be useful, for example to protect assets for children from a previous marriage, to fix who inherits, or to shelter future growth, so each family should take advice.
In practice
Real-world examples.
Example
A married couple with a family farm worth $12 million wants to protect the first spouse's allowance. Their lawyer drafts wills that place assets up to the allowance in a trust on the first death. The survivor receives income while the farm remains within the trust.
Example
A man remarries and has children from his first marriage. He sets up an exemption trust so that his current wife can receive income during her life, but the capital will go to his children. The structure gives the wife support while protecting his children's inheritance.
Example
A couple moves to a country where the unused allowance of the first spouse can be transferred to the survivor. They review their documents with an adviser. They decide to keep the trust anyway because it also protects assets against a future remarriage by the survivor.
Formula
Calculation
Estate tax saved = Amount placed in the exemption trust x Estate tax rate
For illustration, assume each spouse has an exemption of $6,000,000 and that any amount above it is taxed at 40%. These figures are assumed for the example and are set by law, so they can change.
A couple owns $14,000,000. Without a trust, everything passes to the survivor, who dies owning $14,000,000. The taxable amount is $14,000,000 - $6,000,000 = $8,000,000, and tax is $8,000,000 x 40% = $3,200,000.
With an exemption trust, $6,000,000 goes into the trust at the first death, so the survivor owns $8,000,000. The taxable amount is $8,000,000 - $6,000,000 = $2,000,000, and tax is $2,000,000 x 40% = $800,000. The tax saved is $3,200,000 - $800,000 = $2,400,000, which equals $6,000,000 x 40%.Case study
Seen in the real world.
Hartwell and Joan Pryce are a fictional couple in their seventies, with an estate of $13 million made up of a home, an investment portfolio and a small business. Their old wills left everything to the surviving spouse.
Their adviser pointed out that this arrangement would waste the first spouse's tax allowance. They revised their documents so that, on the first death, assets up to the allowance would go into an exemption trust, with Joan or Hartwell as income beneficiary and their two children as final beneficiaries.
In this illustrative case, Hartwell died first and the trust received $6 million. By the time Joan died ten years later, the trust assets had grown to $9 million, and none of that growth was taxed in her estate. The family also valued the way the trust fixed who would inherit the business.
Watch out
Common mistakes.
- Leaving everything to the surviving spouse without considering whether the first spouse's allowance will be lost.
- Assuming the trust fixes itself, when it must be funded correctly with the right assets after the first death.
- Forgetting that tax laws and allowance amounts change, so older documents may no longer suit the family.
Questions
People also ask.
Is an exemption trust the same as a credit shelter trust?
Yes, the names are often used interchangeably, along with bypass trust and family trust.
Can the surviving spouse access the money?
Usually the survivor can receive income and, within limits, capital for support, but full control would bring the assets back into the survivor's estate.
Do I still need one if the unused allowance can be transferred?
Possibly. A trust may offer protection, control and growth shelter that a simple transfer of the allowance does not.
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