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  • Barry Boscoe

Exemption Trust – 2011 and Its Relevancy

An Exemption Trust, by any other name, is still an exemption trust; however it has also been called a bypass trust, B-trust, credit shelter trust, credit trust, family trust, and disclaimer trust. Whatever you call it, it is still a tried and true planning tool for estates of all sizes. Today, advisors are wondering whether the continued use and viability of the exemption trust warrants the time of day, especially with the passage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, also known as the 2010 Tax Relief Act.

The Exemption Trust has been utilized for years as a tool to hold the estate-tax-exempt assets for the survivor’s benefit. The use of this trust helps shield the assets from inclusion in the estate of the surviving spouse, thus reducing the estate taxes incurred at the second death. Due to the 2010 Tax Relief Act, the question on many advisors’ minds is, “is this trust still necessary?” Reason: The 2010 Tax Relief Act allows for any unused federal estate tax exemptions to be portable at the first spouse’s death. This means that when the second spouse dies, the unused portion of the exemption from the first spouse can be added to the second spouse’s exemption. This will create a similar benefit to creating the exemption trust.

Portability provides the survivor complete control over the assets the couple enjoyed as contrasted with the limitations an exemption trust imposes. Some of those limitations are:

1. Powers of the surviving spouse acting as trustee are limited so as not to be treated as a general power of appointment, thus causing inclusion in the estate.

2. Unless an outside trustee is used, the surviving spouse is limited to trust income and access to the principal for an ascertainable standard such as health, support, maintenance, and education.

3. Any tax that is not distributed from the trust is taxed at the highest marginal rate, 35%, of any income in excess of $11,350.00. Contrast this to a single taxpayer paying 35% tax on the excess income over $372,950.00.

So should we all be looking at discontinuing the use of an exemption trust, or maybe, we should continue to utilize the trust for its non-tax benefits? One of the biggest advantages of an exemption trust is the fact that the first spouse to die has assurance that the assets being left will be transferred according to his or her wishes. This protects those assets from the surviving spouse who may either be a spendthrift or possibly remarries. If the surviving spouse were left the assets outright using the portability provisions of the new tax law, the assets which the decedent intended for his or her heirs could be vastly diminished. In addition, this risk of loss will occur if the surviving spouse remarries.

On the other hand, the deceased spouse may want the surviving spouse to have access to the monies left, which could be accomplished with special provisions within the exemption trust, thereby accomplishing two goals, i.e. 1) Protect the assets so they will end up with the heirs as desired, and 2) Provide income and principal to the surviving spouse during the surviving spouse’s lifetime. Without the use of the exemption trust and leaving all of the assets outright to the surviving spouse, the ultimate decision as to whom receives the inheritance is solely in the hands of the surviving spouse.

The 2010 Tax Relief Act was implemented as a temporary compromise and will expire at the end of 2012. Unless Congress acts, the portability provisions may vanish, thus relying on portability may be foolhardy until if and when it becomes permanent. A “catch” to the portability provisions under current law is that the survivor may only inherit the exempt amount from one decedent spouse, thus creating a dilemma if the surviving spouse remarries and the new spouse becomes the first to die. The portability law then instructs that the first decedent’s spouse’s exemption amount is substituted with the second spouse’s, and is thus lost.

Another advantage to the exemption trust is all assets being left in the trust will fully escape future estate taxes on all of the appreciation upon the surviving spouse’s death. If left outright to the surviving spouse, all of the appreciation would then be included in the surviving spouse’s estate upon the surviving spouse’s death and thus subject to estate tax.

Assets left in an exemption trust can be leveraged at the time the surviving spouse decides they may not need all of the assets to support their lifestyle. Life insurance can be purchased using the exempt trust assets, thereby creating a tax-free legacy of not only the assets in the exempt trust, but also the full amount of the death benefit paid from the life insurance policy.

Finally, portability does not provide for generation skipping tax allocations. If the desire is to exempt assets from the next generation’s taxable estate, then the use of an exemption trust may be necessary.

So when sitting down to either review or create a trust, think of not only the tax benefits, but also the non-tax disposition benefits as well.

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