The Use of Trusts in Taxable Estates

For people who will leave behind taxable estates (which, in 2008, are estates of $2 million or more), a major objective in planning your estate will be the incorporation of tax-saving devices. Since the federal estate tax is imposed based on the size of your estate, it’s intuitive to try to remove assets from your estate so that they will not be included in the calculation of your gross estate, while still maintaining to some degree the control and benefits of those assets. One method to accomplish this result is the use of various types of trusts within your estate plan.

One of the most commonly-seen schemes is the use of a marital trust-bypass trust combination. These mechanism are most often used when spouses’ combined estates exceed the exemption amount, and for a practical reason: if all of a spouse’s estate is left outright to the surviving spouse, more total property will be taxed at higher estate tax rates when the survivor dies. If a bypass trust is created, the assets of the trust will be sheltered from estate taxation on the death of the first spouse due to use of the decedent’s credit, and sheltered from tax on the death of the second spouse because the assets will not be part of the second spouse’s estate.

To illustrate with the current 2008 applicable exclusion amount of $2 million, let’s take an example of a married couple owning $4 million in assets. When a bypass trust is used, the entire $4 million may to pass through the estates of both spouses and on to the couple’s children without the imposition of federal estate tax. When the first spouse passes away, the $2 million transferred to a bypass trust is sheltered from taxation under the unified credit available to his or her estate. The rest of the first spouse’s estate, which would be transferred to the surviving spouse outright or in a marital deduction trust, is sheltered from taxation under the unlimited marital deduction. When the surviving spouse subsequently dies, the $2 million in the bypass trust is not taxed because it isn’t included in the surviving spouse’s estate, and an additional $2 million is sheltered by the surviving spouse’s $2 million applicable exclusion amount. It should also be noted that if the assets of the bypass trust have appreciated since the date of the first spouse’s death, the total amount dodging taxation after the surviving spouse’s death may exceed $4 million.

Another commonly-seen trust vehicle designed to remove property from the gross-estate calculation is the irrevocable life insurance trust, or ILIT. Remember that life insurance is a non-probate asset, meaning it passes by contract rather than by a Will. The person or persons who will receive the death benefit after your passing is simply determined by who you select on your beneficiary designation form. Since the proceeds are transferred outside of a will, clients often mistakenly believe that life insurance isn’t “counted” as part of their estate for tax purposes. Unfortunately, that isn’t the case, and the proceeds are included in your taxable estate unless certain planning measures have been taken.

When an ILIT is properly created, the trust itself becomes the legal owner of the life insurance policy, rather than the person in question. The trustee of the trust will purchase the life insurance policy and pay the premiums (or, if a policy is already in existence, will manage the existing policy that is transferred into the trust). Once the individual dies, the death benefit will be distributed according to the terms of the trust instrument. As the name of the trust suggests, the transfer of the policy to the trust is “irrevocable” and cannot be changed. The vehicle works because, according to the law, life insurance proceeds payable to your selected beneficiaries is taxable in the decedent-insured’s estate only if the insured has “incidents of ownership” in the policy. By not only giving up technical “ownership” of the property but also certain outlined parameters of control over that policy by placing it in the ILIT, you give up the “incidents of ownership” necessary to exclude the life insurance from your estate.

Other trust options are available to reduce the size of your gross estate for estate tax purposes, such as the creation of trusts for minors or a charity, to which lifetime gifts will be made. The experienced Estate Planning attorneys at Garg & Associates are here to explain the various trust vehicles and planning mechanisms available for incorporation in your estate plan, and will guide you through the drafting, execution and implementation of these instruments to aid you in minimizing your estate tax liability.

We invite you to contact us for a consultation. Call Garg & Associates, PC at 281-362-2865 or complete our contact form.

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Garg & Associates, PC | 21 Waterway Avenue, Suite 300 | The Woodlands, Texas 77380 Please call 281-362-2865 | Fax: 866-743-4506
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