What Is an Exemption Trust? Definition, Example, 8 Facts

Frequently, an exempt trust is also known as an exemption trust. The assets of a married couple are placed in a trust or in the name of a separate organization by an exempt trust.

What Is an Exemption Trust?

A trust designed to significantly minimize or eliminate federal estate taxes on the estate of a married couple. This form of estate plan is created as an irrevocable trust to hold the assets of the first spouse to pass away. A trust exemption does not transfer assets to the surviving spouse.

What Is an Exemption Trust?

As its name implies, an irrevocable trust cannot be altered or revoked without the beneficiary’s consent. A major advantage of an irrevocable trust is that it removes assets from the grantor’s taxable estate, so reducing the estate’s tax burden.

A trust’s assets may include cash, investments, a home, life insurance policies, a business, precious gems, fine art, and antiques.

How an Exemption Trust Works

A common estate planning tool for wealthy married couples is an exemption trust. The primary objective of an exemption trust, also referred to as a bypass trust or credit shelter trust, is to reduce a couple’s federal estate tax liability.

Using an exemption trust, the surviving spouse does not inherit the deceased spouse’s assets. This distinguishes its provisions from the provisions of most wills.

The surviving spouse is “bypassed,” and the assets of the deceased are held in a trust. When the surviving spouse passes away, the assets are dispersed to the beneficiaries of the trust (typically their children if they had any).

Due to the fact that the surviving spouse did not inherit the assets directly, the beneficiaries are not liable for any estate taxes when they receive the trust assets following the surviving spouse’s death.

What Is an Exemption Trust?

A further advantage of an exemption trust is that the surviving spouse retains access rights to the trust’s assets for the length of his or her life. For instance, a surviving spouse can use both the income and principal of the trust to pay for specified medical or educational expenditures.

2017 Federal Tax Law Benefits Exemption Trusts 

The exemption threshold for estate taxes was increased by the tax legislation passed by Congress in late 2017. In actuality, it doubles the amount of monetary value that couples may transfer tax-free.

Prior exemption amounts were just shy of $5,500,000 per individual. For tax years 2018 through 2025, the exemption was extended to about $11.2 million as a consequence of the tax reform.

Therefore, if the gross value of an exemption trust grantor’s estate is less than $11.2 million, no estate taxes are due when that individual dies.

And even if the estate’s entire worth exceeds $11.2 million, only the amount above the exemption level is taxed. In other words, if an estate’s value exceeds the exemption level by $100,000, just $100,000 is taxed and not the $11.2 million.

Example of an Exemption Trust

Frequently, exemption trusts employ an AB trust structure in which two trusts, one belonging to each couple, are financed with about the equal number and quantity of assets. Consider that Priya and Krishnan have established an exemption trust using the AB trust method.

When Priya dies, her assets are transferred to trust B, and the excess over the exemption level (about $11.2 million) is financed into trust A to avoid federal estate taxes.

What Is an Exemption Trust?

During his lifetime, Krishnan will have access to the fund’s earnings. Utilizing Krishnan’s exemption limit, Trust A passes $11.2 million (the federal exemption limit) tax-free to his beneficiaries upon his death. The balance is subject to tax. Nonetheless, the end recipient of trust B receives monies tax-free.

Primary Requirements

To take advantage of federal estate-tax regulations, an exemption trust, usually referred to as a bypass trust since it allows trust assets to avoid federal taxes, must fulfill a number of legal conditions.

It must be irreversible, meaning that neither the trustor, who funds the trust, nor the trustee, who administers the trust, may revoke it. In addition, they cannot alter the beneficiaries or alter the trust in any other manner. All of the assets of an exemption trust must be kept in the trust’s name.

Federal Exemption

A spouse can benefit from an exemption trust’s assets without acquiring ownership of them. The financing level of an exemption trust is a vital feature. Each citizen of the United States is free from the federal estate tax under federal tax law.

What Is an Exemption Trust?

For a marriage to fully benefit from each spouse’s personal estate-tax exemption, the monies put in an exemption trust should not exceed the federal estate-tax exemption.

A person who passes away in 2011 or 2012 is free from the estate tax to the tune of $5 million. The amount of this exemption may be altered in the future by Congress.

Tax Advantages

Because the assets of the exemption trust are not included in the estates of either spouse, they are free from federal estate tax provided their total value does not exceed the federal estate-tax exemption in the year of the death of the last surviving spouse.

For couples with substantial estates, an exemption trust retains the surviving spouse’s estate tax exemption.

It prevents the transfer of all of the deceased spouse’s assets to the surviving spouse, which may cause the value of the deceased spouse’s estate to exceed the federal estate tax exemption.

Other Benefits

An exemption trust provides benefits in addition to its tax benefits. It allows both couples to make estate-planning decisions, as opposed to leaving them up to the survivor.

What Is an Exemption Trust?

An exemption trust also ensures that assets are distributed to children or other beneficiaries, avoiding potential problems if the surviving spouse remarries or reducing the inheritance wastefully.

Conclusion

A tax-exempt trust is a type of estate planning designed to decrease the tax obligation associated with contributions, particularly those made upon death.

When a person dies, his estate, which consists of the physical property, cash, and other possessions he leaves behind, is often taxed by the government upon transfer to his heirs.

Establishing a trust in which the assets are owned jointly or individually by the original owner and his or her heirs, but apart from the owner’s personal assets, is one option to reduce the burden of inheritance and death taxes.

There are two sorts of trusts: non-exempt trusts, which demand transfer taxes on the assets owned by the trust, and exempt trusts, which do not require transfer taxes.

FAQ

There are two types of trusts: non-exempt trusts, which require taxes to be paid upon the assets held by the trust upon transfer; and exempt trusts, which do not require taxes to be paid upon transfer of the assets. In an exempt trust, the assets of a married couple will be placed in a trust.
A major disadvantage of a bypass trust is the loss of the second income tax basis step up at the death of the surviving spouse for the assets in the bypass trust. When someone dies, the capital basis of the person’s assets, with certain exceptions, is adjusted to the fair market value at the person’s date of death.
Exemption equivalent trust is a trust funded by a decedent’s will with property that will pay surviving spouse the income from the trust, while the trust itself is not part of his or her estate. It qualifies for the federal unified gift and estate tax credit which is equivalent to transferring $ 600,000 tax free.
Under a GST exempt trust, the trust assets may be insulated further from estate and gift taxes in the future by making sure that the provisions of the trust do not cause the trust assets to be included in the beneficiaries’ estates for estate tax purposes.
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Pat Moriarty
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