If I need estate-tax planning, how does it work?

Generally, the first tool to use is a special trust called a bypass trust or alternatively called a credit-shelter trust. Basically, at the time of the first spouse’s death, the first spouse’s will or living trust puts assets up to the applicable exemption amount into the bypass trust. That’s where the bypass trust gets it name: by putting assets into the bypass trust, the assets bypass the surviving spouse. The remaining property that does not go into the bypass trust may pass outright to the surviving spouse, or the property may go into one or more other types of trusts for the property not in the bypass trust.

While the surviving spouse will typically receive income and a limited ability to invade the principal of the trust (get to the money in the trust earlier than the trust intends to disburse the money), it will never be owned by the surviving spouse, thus it will not be in the surviving spouse’s estate at the time of the surviving spouse’s death.

A bypass trust can be put into a will or into a living trust depending on your needs.

Here are a few simplified examples showing approximate numbers. Please note, these are simplified examples¹ and in reality, things are more complicated.

Without bypass trust

• H and W married with $9 million in assets;
• H dies in 2014 with $7 million of the $9 million;
• H’s estate plan had no tax planning, and he leaves his $7 million outright to W.
• No tax is due at H’s death due to the marital deduction exemption.
• W dies later in 2014 with all $9 million;
• W’s estate pays ($9 million minus $5.34 million) multiplied by 40% for estate tax of approximately $1.46 million in estate taxes.

With bypass trust

• H and W married with $9 million in assets;
• H dies in 2014 with $7 million of the $9 million;
• H’s estate plan leaves $5.34 million to a bypass trust;
• H leaves remaining $1.66 million outright to W and pays no tax due to the ‘marital deduction’ exemption even though he died with more than $5.34 million;
• W earns income off the trust and then W dies later in 2014;
• W’s assets total $4.66 million ($2 million plus H’s $1.66 million gift plus some income from investments and the bypass trust income) at time of death and W’s executor uses her $5.34 million exemption to pay no tax.
• The bypass trust gives the remaining property in the bypass trust to children or other beneficiaries.
• Zero federal estate tax paid, resulting in a savings of almost $1.5 million!

The cost of tax planning now is well-worth the small up-front costs of estate planning.

So we’ve seen the bypass trust is a good way to remove an amount of assets from an estate equal to the exemption amount in existence at the time of death of the first spouse to die.

While you can think of this as doubling the applicable exemption amount, it is not guaranteed that the second spouse to die’s exemption amount will be the same as the first spouse to die’s exemption amount; the laws change all the time.

Please note that the above examples are simplified, particularly when it comes to tax-deferred assets like retirement accounts. Sometimes it’s better to pay some estate tax on the tax-deferred assets in order to not accelerate income tax on the deferred assets. Many times, income taxes are accelerated on tax-deferred assets if the tax-deferred assets are left to a bypass trust. This choice depends on the composition of your assets and your desired goals and wishes.

There are other options available to reduce estate taxes even more for estates that are larger than double the applicable exemption amount. They can be irrevocable life insurance trusts (“ILITs”), other trusts, gifting schemes, charitable gifts and charitable trusts, qualified terminable interest property trusts (“QTIPs”), and family limited partnerships. These options can be complex, but have potential to provide even more tax benefits for the high net worth individual. Discussing these more complex options, however, is beyond the scope of this article.

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