Exemption Trust Definition

What is an Exempt Trust?

An exempt trust is a trust designed to significantly reduce or eliminate domain taxes on the estate of a married couple. This type of estate plan is set up as a irrevocable trust who will hold the property of the first member of the couple to die. An exempt trust does not pass assets to the surviving spouse.

As its name suggests, an irrevocable trust cannot be changed or invalidated without the permission of the beneficiary of the trust. One of the main advantages of an irrevocable trust is that it removes assets from the taxable estate of the settlor, thereby reducing the tax liability of the estate. The assets of an irrevocable trust may include one or more of the following: money, investments, a home, life insurance policies, a business, precious stones, fine art or antiques.

Key points to remember

  • An exemption trust helps reduce a married couple’s estate taxes by placing their assets in a trust after the death of the couple’s first member.
  • Exempt trusts are set up as irrevocable trusts, so they cannot be changed or invalidated without the permission of the beneficiary of the trust.
  • The surviving spouse still has certain rights of access to the property even if the property is held in trust.

How an Exempt Trust Works

An exempt trust is a popular estate planning tool for affluent married couples. The primary purpose of an exempt trust, also known as a bypass trust or a credit protection trust, is to mitigate a couple’s federal estate tax. With an exemption trust, the surviving spouse does not inherit the assets of the first member of the deceased couple. This makes its provisions very different from those of many wills.

The surviving spouse is “bypassed” and the deceased’s assets are held in a trust. On the death of the surviving spouse, the assets are distributed to the beneficiaries (usually their children if they had any). Since the surviving spouse did not directly inherit the assets, beneficiaries are not liable for inheritance tax when they receive the assets from the trust after the death of the surviving spouse.

Another advantage of an exempt trust is that before the death of the surviving spouse, he still retains several rights of access to the assets of the trust for the rest of his life. For example, a surviving spouse can draw on both trust income and trust capital to pay for certain medical or educational expenses.

2017 Federal Tax Act Benefit Exempt Trusts

The tax law passed by Congress at the end of 2017 raised the ceiling for exemption from inheritance tax. In effect, it doubled the amount of cash value that couples can transfer without being subject to inheritance tax. The previous exemption amount was just under $5.5 million per person. As a result of tax reform, the exemption was increased for an unmarried person to $11.4 million for the 2018 to 2025 tax years.

Therefore, if the gross value of an exempt trust settlor’s estate is less than $11.4 million, when that person dies, no estate tax is payable. And even if the total value of the estate exceeds the $11.4 million limit, only the amount above the exemption level is taxable. In other words, if an estate is worth $100,000 over the exemption limit, only the $100,000 is taxed, rather than the $11.4 million.

Exempt Trust Example

Exemption trusts often use an AB trust system in which two trusts, one owned by each spouse, are funded with roughly the same amount and number of assets. Suppose Priya and Krishnan have created an exemption trust using the AB trust system. When Priya dies, her assets are transferred to Trust B and the excess over the exemption limit (in this case, approximately $11.4 million) is funded into Trust A to avoid federal taxes on successions. The fund and its income are available to Krishnan during his lifetime. Upon his death, $11.4 million (as defined by the federal exemption limit) of Trust A passes tax-free to its beneficiaries, using Krishnan’s exemption limit. The remaining amount is taxed. However, funds from Trust B are transferred tax-free to the ultimate beneficiary.