Tax Planning Trusts
Bypass Trust or Credit Shelter Trust
A "Bypass Trust", also known as a "Credit Shelter Trust", is a common type of Trust married couples include in their Wills or Revocable Living Trust to reduce or even eliminate state and federal estate taxes.
Estate taxes for both the United States government and the State of Washington apply to taxable estates with a value that exceeds a certain threshold amount. For federal estate taxes, the filing threshold will vary over the next three years, as follows:
| 2009: | $3,500,000 |
| 2010: | No Estate Tax |
| 2011 and beyond: | $1,000,000 |
Because assets below this filing threshold are not taxable, these amounts are also referred to as the "exclusion amount". For the State of Washington, the exclusion amount is $2,000,000, with substantial additional deductions available for qualified farmland and farming equipment.
For both state and federal tax purposes, there is an unlimited deduction available for property transferred to a spouse (unless either spouse is not a US citizen; see the discussion of Qualified Domestic Trusts below). In other words, a decedent may leave an unlimited amount of assets to his or her surviving spouse, tax free, without relying on the state or federal exclusion amounts referenced above. However, this can result in unnecessary estate taxes being due on the estate of the second spouse to die. To reduce or eliminate this tax liability, and potentially double the amount that may pass tax free to their heirs, couples can combine the exclusion amounts applicable to their respective estates by incorporating a Bypass Trust into their Wills or Revocable Living Trust. Upon the death of the first spouse, the Bypass Trust is created for the benefit of the surviving spouse, and may be funded with assets up to the highest applicable state or federal exclusion amount. In doing so, the first spouse to die uses his or her exclusion amount to fund the Bypass Trust, rather than relying on the unlimited marital deduction. The surviving spouse is the beneficiary of the Trust; certain limits are placed on his or her rights to use of the Trust assets to ensure they remain separate from the surviving spouse’s estate.
Here’s a simple example of how the Bypass Trust works. Let’s assume a married couple has an estate worth $2 million. The husband dies in 2009, leaving his half of the marital estate ($1 million) directly to his wife. The wife dies in 2011, with an estate worth $2 million; no Washington estate tax would be due, but after applying the federal exclusion amount of $1 million, federal estate tax would be due on the other $1 million in the wife’s estate. Had the husband created a Bypass Trust for the wife’s benefit, he would have used his exclusion amount by placing $1 million in a bypass trust, keeping those assets out of his wife’s estate, thereby reducing her taxable estate to $1 million and completely avoiding both state and federal estate taxes.
Upon the death of the surviving spouse, the remaining Trust assets pass directly to contingent beneficiaries, such as children or grandchildren, potentially tax free; some tax may be due because the exclusion amounts for state and federal tax purposes are not the same. For example, in 2009, the Washington exclusion amount is $2 million while the federal exclusion amount is $3.5 million. The estate of a decedent dying in 2009 would be permitted to fund a credit shelter trust with up to $3.5 million in assets; for Washington estate tax purposes, an election could be made to defer any Washington estate tax due on the $1.5 million difference until after the death of the surviving spouse, by making what is known as a QTIP election. Moreover, the state would only impose a tax on that portion of the assets remaining after the death of the surviving spouse.
Qualified Domestic Trust
A Qualified Domestic Trust (QDOT) is a tax-planning trust available to married couples when either spouse is not a US citizen, and is used because the unlimited marital deduction is unavailable if the surviving spouse is not a US citizen.
Without a QDOT, if the surviving spouse is not a US citizen, the estate of the first spouse to die will have to pay estate tax if the taxable estate exceeds the applicable state or federal exclusion amounts. However, if assets in excess of the exclusion amount are placed in a QDOT, the tax on these assets will be deferred. A QDOT may be used to defer both state and federal estate taxes.
The surviving spouse may receive distributions of principal and income from the QDOT. Any income distributed is subject to income tax; distributions of principal are subject to state and federal estate taxes, unless the distribution qualifies as a hardship under the IRS regulations. After the death of the surviving spouse, any assets remaining in the QDOT are subject to state and federal estate taxes.
The unlimited marital deduction is not available to non-citizen spouses because of the possibility that assets will be removed to a foreign country, where they will no longer be subject to any US taxes in the future; it is a way to ensure that tax is paid before the assets are removed. Other rules governing QDOTs, such as requiring that at least one trustee be a US citizen or US corporation, are also in place for this purpose. However, deferring estate taxes with a QDOT helps to create a source of funds for the support of a surviving spouse. Moreover, if the surviving spouse becomes a US citizen after the death of his or her spouse, and was a resident of the United States at all times between the death of his or her spouse and becoming a US citizen, both the State of Washington and the federal government will permit the unlimited marital deduction for any remaining QDOT assets.
Irrevocable Life Insurance Trust
An Irrevocable Life Insurance Trust (ILIT, for short), is another type of Trust used to reduce or eliminate estate taxes; it can also create a pool of funds for the support of the insured’s family that is not subject to estate tax upon the death of the insured. An ILIT accomplishes this by placing one or more life insurance policies into an irrevocable trust. When done properly, the death benefits are not subject to estate tax. Life insurance is includable in the decedent’s taxable estate if he or she held any “incidents of ownership” in the policy within 3 years of the date of death; if the ILIT purchases the insurance, all “incidents of ownership” belong to the trust, not the insured, and the death benefits are therefore not subject to estate tax. Existing policies may be transferred into the trust, and the death benefits will not be taxable provided the insured lives beyond the three year look-back period.
Other types of tax planning trusts, such as Charitable Remainder Trusts, and even other types of entities, such as Family Limited Partnerships and Limited Liability Companies can be used to help minimize or eliminate potential estate taxes.
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