How can a trust lower the federal estate tax liability?
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UPDATED: Jun 19, 2018
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Everyone gets a “credit” against Federal Estate Taxes of $550,800 on an exemption amount of $1.5 million in 2004 and 2005 (or $2 million ‘Everyone’s estate below a minimum amount is exempted from Federal Estate Taxes. Only about 1% of estates are taxed at the federal level. The amount exempted in 2009 is $ 3.5 million and then Federal Estate Taxes will be repealed in 2010, but only for one year. In 2011 it will be reinstated with a minimum of $1 million (though Congress could choose to extend the repeal). That minimum amount can be decreased for an individual if the deceased made gifts subject to gift tax during his/her lifetime. Gifts subject to gift tax are gifts of more than $11,000 made to any one person in any year prior to 2006, or $12,000 to any person in any year starting in 2006, or $13,000 to any person in any year starting in 2009. So, someone who dies in 2009 who has made gifts in the amount of $800,000 during her life that were subject to gift tax will have to pay taxes on her estate for any amounts over $2.7 million ($3.5 million minimum minus $800,000). Individuals and married couples with a total estate value less than the current exemption level don’t have to worry about Federal Estate or Gift Tax
There is also an unlimited marital deduction for all amounts one spouse leaves to the other, as long as the inheriting spouse is a US citizen. So estate taxes aren’t an issue when one spouse dies and leaves most of the estate to the other. A problem can arise when the second spouse dies and the estate goes to children or other relatives or friends. If the separate estate for each spouse is below the tax minimum, but the combined estates would be over the minimum, the estate might have to pay extensive taxes when the second spouse dies.
The first spouse can avoid this by establishing a tax by-pass Trust at his/her death to hold property for children or other Beneficiaries at the death of the second spouse. While the second spouse is still alive the Trust assets will be used to provide for the surviving spouse. At the death of the second spouse the Trust assets will be distributed to the named Beneficiaries. Because the second spouse never owned the assets in the Trust, those assets don’t become part of the second spouse’s estate for purposes of calculating Federal Estate Taxes.
Note that some states have state estate or inheritance taxes that aren’t covered by this discussion.