There is an estate planning tool that may reduce the amount of taxes owed by your estate: the “Bypass Trust” sometimes referred to as a credit shelter trust or A-B Trust. Minimizing estate taxes helps your heirs and beneficiaries to retain more of your assets.
Between January 1, 2011 and December 31, 2012, each person is allowed to exempt the first $5 million of their estate from the estate tax. The $5 million exemption is referred to as the unified credit. Any amount above $5 million is taxed at a rate of 35%. Use of a bypass trust allows married couples to maximize the benefit they receive from the unified credit against federal estate taxes, sheltering up to $10 million from federal estate tax.
How it works: each spouse creates an individual revocable living trust, and transfers their assets into their trusts. It is important to divide the assets so that each trust has close to the same value. Spouses can transfer an undivided one half interest in real estate they own to each trust.
At the first spouse’s death, the bypass trust is divided into two separate trusts: the Marital or A Trust and the non-Marital or B Trust. The first $5 million worth of the decedent’s property will go into the B Trust, and is exempt from federal estate tax. The assets in the B Trust can be used by the surviving spouse and any dependents, such as children. There are restrictions on how the trust property can be used, generally health, education, support and maintenance in his or her accustomed manner of living.
Anything over the first $5 million will go into the A Trust. The assets in the A Trust can only be used by the surviving spouse. These assets are subject to the federal estate tax, but the tax is deferred until the surviving spouse’s death because gifts between spouses are not subject to tax.
Upon the surviving spouse’s death, the first $5 million of his or her estate will pass estate-tax free to the designated beneficiaries. Any remaining amount in the B Trust also will pass estate-tax free to the final beneficiaries, regardless of how it may have increased in value, and without any of the assets being accessible to the creditors of the surviving spouse. The remaining assets in the A Trust will be subject to estate tax as part of the surviving spouse’s estate. After the estate taxes are paid, any amount remaining passes to the beneficiaries.
There are some drawbacks. Beside the restrictions on how the property in the A trust can be used, it is important to keep good records, and be meticulous in keeping up with the forms that must be filed for tax purposes. There may be a sense of distrust that the assets are tied up in a trust rather than being immediately available.
It will be up to Congress to establish a new unified credit amount, since the law is scheduled to revert to a maximum of $1 million come January 1, 2013. If the exemption is that low, bypass trusts may become very popular.