How to Avoid Estate Tax

Federal tax law allows an unlimited transfer of property to a surviving spouse without imposing any estate tax. This is a result of the “unlimited marital deduction.” In addition to the unlimited marital deduction, Federal tax law allows every individual to transfer a specific amount tax-free at death to a beneficiary or beneficiaries other than a spouse. This amount, called the “exemption equivalent amount,” is currently $2 million and is scheduled to increase next year to $3.5 million. In 2010, the federal estate tax is scheduled to be completely repealed, only to be re-instated in 2011 with the exemption equivalent amount of only $1 million. Congress may change this law before 2011, but there is no guarantee.

If you are married and you leave everything to your spouse upon your death, your estate will not have to pay any estate taxes due to the effect of the unlimited marital deduction. However, upon the death of your spouse, all amounts in excess of the unified credit amount will be subject to Estate Tax at rates starting at 45%.

For married couples with assets in the range of $2 million to $4 million, the way to avoid or minimize this tax problem is to establish an estate plan so that upon the death of the first spouse a “Family Trust” (also called a “Credit Shelter Trust” or “ByPass Trust” or “B Trust”) is created. Typically, the purpose of the Family Trust is to provide support for the surviving spouse during his or her lifetime, with the remainder of the trust then going to the children upon the death of the surviving spouse.

Example of Estate Plan Without a Family Trust:

John and Mary (husband and wife) have a combined estate with a total of $3 million in jointly-owned assets. John dies in March, 2008. Upon John’s death, his estate all transfers to Mary by right of survivorship; as a result of John’s unlimited marital deduction, no estate tax is due. Unfortunately, Mary dies 6 months after John. When Mary dies, her estate, which is now $3 million, will pay estate tax of $450,000 (45% of the $1 million which exceeds Mary’s $2 million exemption equivalent amount).

Example of Estate Plan With a Family Trust:

Same scenario except that John and Mary each have a trust containing $1.5 million in assets. John dies in March, 2008. Upon John’s death, his trust becomes a Family Trust instead of being left directly to Mary. Mary is named as the trustee of the Family Trust and is allowed to receive all the income from the Family Trust plus five percent or five thousand dollars from the principal of the Family Trust every year. Mary also has the right to withdraw additional principal from the Family Trust so long as the money withdrawn is not used by Mary to exceed the standard of living established while John was still alive.

Mary dies 6 months after John. Upon the death of Mary, the Family Trust terminates and the $1.5 million in that trust goes to John and Mary’s children free of Estate Tax. Mary’s trust also terminates at that time and the $1.5 million in her trust also goes to their children free of Estate Tax. The result is a tax savings of $450,000.

Flexible Planning Using a Disclaimer-Funded Family Trust:

Given the uncertainty of the future estate tax laws, many married couples desire to preserve post-death flexibility as to whether to establish a Family Trust upon the death of the first spouse. To allow this flexibility, couples can establish estate plans leaving everything outright to the surviving spouse, but providing a Disclaimer-Funded Family Trust in the event that the surviving spouse chooses to file a disclaimer. The idea is that the surviving spouse will meet with the estate planning attorney after the death of the first spouse to decide whether to disclaim and, if so, how much to disclaim. In making this decision, the surviving spouse would consider the amount of the assets, the status of the estate tax laws at that time, and his or her own economic needs. A sufficient amount could be disclaimed to fully fund the Family Trust of the first spouse to die or to partially fund the Family Trust. Partial funding of the Family Trust might be preferred because the amount not disclaimed, which will still be owned outright by the surviving spouse, may be less than the applicable exclusion amount available to that surviving spouse.

Examples of Estate Planning With a Disclaimer-Funded Family Trust:

Example 1: Same scenario as above – John and Mary each have a trust containing $1.5 million in assets. John dies in January, 2009 ($3.5 million exemption). Upon John’s death, his trust distributes everything directly to Mary, subject to Mary’s right to disclaim. Mary decides not to disclaim because her total estate of $3 million is less than the $3.5 million exemption, and Mary believes that Congress will not allow the exemption equivalent amount to drop lower than $3.5 million.

Mary dies 6 months after John. When Mary dies, her $3 million estate will not pay any estate tax because it is less than her $3.5 million exemption. 

Example 2: Same scenario as above – John and Mary each have a trust containing $1.5 million in assets. John dies in January, 2011 ($1 million exemption). Upon John’s death, his trust distributes everything directly to Mary, subject to Mary’s right to disclaim. Mary decides to disclaim $1 million of John’s $1.5 million in assets in order to fully utilize John’s $1 million exemption.

Mary dies 6 months after John. When Mary dies, John’s Family Trust terminates and the $1 million in that trust goes to John and Mary’s children free of Estate Tax. Mary’s trust also terminates at that time and the $2 million in her trust will pay estate tax of $435,000. Had Mary not disclaimed $1 million upon John’s death, her estate of $3 million would pay estate tax of $945,000. The result of Mary’s disclaimer is a tax savings of $510,000.

Disadvantages of Using a Disclaimer-Funded Family Trust:

The reliance on a disclaimer-funded family trust can be problematic for several reasons. One potential problem is that after the death of the first spouse, the surviving spouse might change his or her mind and be unwilling to disclaim even though this is advisable for tax and estate planning purposes. Second, because the decision to disclaim must be made within 9 months after the first spouse’s demise and before the surviving spouse accepts any benefits from the assets to be disclaimed, the surviving spouse might inadvertently accept benefits before disclaiming, thereby frustrating the attempt to disclaim.