How can trusts reduce the federal estate tax?

Applicable Exclusion Amount
Just as every person’s estate is subject to the Federal estate tax, each person also receives a fixed dollar amount that can be applied to the amount of estate tax that is actually owed. This credit is known as the “unified credit” or the “applicable exclusion amount” and operates to reduce the amount of federal estate tax that must be paid.

As a credit, the applicable exclusion amount can only be used when the estate actually owes tax. An estate that doesn’t owe any taxes or owes less than the available unified credit simply doesn’t pay any Federal estate tax. The estate does not receive a payment from the I.R.S for the amount of available, but unused credit. The applicable exclusion amount is also personal, meaning that it cannot be shared or transferred between people or estates. This inability to transfer the credit means that any amount which is not used at the time of death simply expires.

Taxable Estate
The taxable estate is the dollar amount that represents the total of the fair market value of everything a person owns at the time of death, less the allowable deductions. Allowable deductions include items such as debts, funeral costs, transfers to qualified charitable organizations, and administration expenses. The value of all property that is transferred to a surviving spouse with United States citizenship is also an allowable deduction, which is often called the “unlimited marital deduction.”

All allowable deductions are subtracted from the deceased’s gross estate to determine the taxable estate. Once the taxable estate is known, the applicable exclusion amount is applied to determine whether any amount of tax must be paid.

Unlimited Marital Deduction and the Taxable Estate
Although the unlimited marital deduction allows a surviving spouse to receive the deceased spouse’s entire estate without incurring any Federal estate tax, it also prevents any use of the deceased spouse’s applicable exclusion amount.

When all of the deceased spouse’s property is transferred to the surviving spouse the deceased spouse is left without a taxable estate. Although there won’t be any tax due, the deceased spouse’s applicable exclusion amount remains unused and will simply expire.

For those who have combined estates significant enough to incur Federal estate tax, this loss of the applicable exclusion amount will most often affect their children. Failure to use the unified credit is not a concern when the property is transferred from the first deceased spouse to the surviving spouse. The concern with failing to use the first deceased spouse’s unified credit comes when the second spouse dies and passes the combined estates of both spouses.

Example Scenario
In 2006 Howard and Marion have individual estates valued at $2,000,000 and two children, Richie and Joanie. These basic facts will be used in both of the following examples, which are designed to show the interaction of the unlimited marital deduction with the applicable exclusion amount and the use of trusts to maximize the tax benefit available when a married couple’s combined estate is passed on to the next generation.

Note that these examples would apply without any regard to which of the two spouses dies before the other.

Estate Values

Without a Credit Shelter Trust
Howard dies in 2007 and, as is typical, uses his will to leave all of his individually owned property to his spouse Marion. The entire $2,000,000 passes to Marion and is combined with her existing $2,000,000 to give her a total estate of $4,000,000. Using the unlimited marital deduction, Howard’s $2,000,000 is subtracted from his gross estate to give him a taxable estate of zero. Without a taxable estate, Howard’s estate does not owe any Federal estate tax. However, without owing any tax, Howard’s $2,000,000 applicable exclusion amount cannot be applied and remains unused.

When Marion dies in 2008 her will divides the full amount of her $4,000,000 estate equally between Howard and Marion’s children. The $2,000,000 applicable exclusion amount available in 2008 can be subtracted from her $4,000,000 taxable estate to leave a balance of $2,000,000 for which the Federal estate tax must be calculated. As shown, the final result is $1,550,000 being given to each child.

Credit Shelter Trusts

In order to make use of the deceased spouse’s applicable exclusion amount, the deceased spouse must have a taxable estate. However, as all estate property given directly to the surviving spouse is excluded from the taxable estate, it would seem that the only way to create a taxable estate is to give a portion of the estate to someone other than the surviving spouse.


See More

Federal Estate Tax Calculator
Basis of the federal estate tax
Who pays for the funeral
Who is responsible for the deceased’s debts
Intestacy Evaluators

Who Gets The Estate?

Open the Intestacy Evaluators℠ and Federal Estate Tax Calculator for the answers.