Legal Definitions - exemption trust

An exemption trust, also known as a bypass trust, AB trust, or credit shelter trust, is a sophisticated legal arrangement used primarily by married couples with substantial assets to minimize potential estate taxes. Its core purpose is to ensure that both spouses' individual estate tax exemptions are fully utilized, preventing the deceased spouse's exemption from being "lost" or merged with the surviving spouse's.

Here's how it generally works: When the first spouse passes away, a portion of their estate, typically up to the current federal estate tax exemption amount, is placed into this irrevocable trust. The assets within this trust are designated for beneficiaries other than the surviving spouse, most commonly their children or grandchildren. While the surviving spouse usually cannot control the principal assets of the trust, they often receive income generated by the trust for the remainder of their life. Upon the subsequent death of the surviving spouse, the assets held within the exemption trust pass directly to the designated beneficiaries without being included in the surviving spouse's taxable estate. This strategy effectively "shelters" the deceased spouse's exemption, allowing the surviving spouse to use their own full exemption for their separate assets.

While once a very common estate planning tool, changes in federal tax law, such as significantly increased exemption amounts and the ability to transfer a deceased spouse's unused federal exemption to the survivor (known as "portability"), have reduced its widespread applicability. However, exemption trusts can still be valuable in specific situations, particularly for couples residing in states that impose their own estate taxes where portability may not apply, or for those with very large estates seeking to lock in tax benefits or manage inheritances for specific heirs. Due to their complexity and potential costs, expert legal and financial advice is crucial when considering an exemption trust.

Here are some examples illustrating how exemption trusts can be applied:

• Scenario: Navigating State Estate Taxes Without Portability

  Mr. and Mrs. Chen live in a state that imposes its own estate tax, and unlike federal law, this state does not allow for the portability of a deceased spouse's exemption. They have a combined estate valued at $15 million. When Mr. Chen passes away, his will directs $5 million (his portion, up to the state's exemption limit) into an exemption trust for their children. Mrs. Chen receives income from this trust for her lifetime to help maintain her lifestyle. When Mrs. Chen later passes away, the $5 million in the exemption trust passes directly to their children without being subject to state estate tax in Mrs. Chen's estate. This allows Mrs. Chen's own $10 million estate to fully utilize her individual state estate tax exemption. This strategy ensures both Mr. and Mrs. Chen's state exemptions are fully used, significantly reducing the overall state estate tax burden on their heirs.

• Scenario: Ensuring Inheritance for Specific Heirs

  Sarah and David are a married couple with a combined estate of $20 million. Sarah has two children from a previous marriage, and she wants to ensure they receive a specific portion of her assets upon her death, regardless of what happens to David's estate later. Sarah establishes an exemption trust in her will. When Sarah passes away, $8 million (her portion, up to the federal exemption amount) is placed into this trust for her children. David is granted the right to receive income from this trust for his remaining life, providing him financial support. Upon David's subsequent death, the $8 million in the exemption trust goes directly to Sarah's children. These assets are not considered part of David's estate for tax purposes, allowing David's own estate to utilize his full federal estate tax exemption for his remaining assets. This ensures Sarah's children receive their inheritance as intended, protected from being taxed as part of David's estate.

• Scenario: Protecting Against Future Tax Law Changes for Very Large Estates

  The Millers are a very wealthy couple with a combined estate of $50 million. While federal estate tax exemptions are currently high and portable, they are concerned about potential future changes in tax laws that might reduce these exemptions. When Mr. Miller passes away, his will directs $12 million (his share, up to the current federal exemption amount) into an exemption trust for their children. Mrs. Miller receives income from this trust. Years later, when Mrs. Miller passes away, the $12 million in the exemption trust passes to their children. This $12 million is not counted against Mrs. Miller's estate tax exemption. Even if federal estate tax exemptions were significantly lower at the time of Mrs. Miller's death, the assets in the exemption trust would still be protected under Mr. Miller's original exemption amount, effectively "locking in" that tax-free transfer. This strategy provides a degree of certainty against future legislative changes for a portion of their very large estate.