Exemption Trust

What Is an Exemption Trust?

An exemption trust is a trust designed to drastically reduce or eliminate federal estate taxes for a married couple's estate. This type of estate plan is established as an irrevocable trust that will hold the assets of the first member of the couple to die. An exemption trust does not pass the assets along to the surviving spouse.

As its name suggests, an irrevocable trust cannot be changed or invalidated without the permission of the trust beneficiary. A primary benefit of an irrevocable trust is that it removes assets from the grantor’s taxable estate, thereby diminishing the estate’s tax liability. Assets in an irrevocable trust could include one or more of the following: cash, investments, a house, life insurance policies, a business, precious gems, fine arts, or antiques.

How an Exemption Trust Works

An exemption trust is a popular estate planning tool for affluent married couples. The primary goal of an exemption trust, which is also known as a bypass trust or credit shelter trust, is to mitigate a couple’s federal estate tax liability. With an exemption trust, the surviving spouse does not inherit the assets of the first member of the couple to pass away. This makes its provisions very different than that of many wills.

The surviving spouse is “bypassed,” and the deceased’s assets are held in a trust. When the surviving spouse dies, the assets are distributed to the trust's beneficiaries (typically their children if they had any). Because the surviving spouse did not inherit the assets directly, the beneficiaries are not held responsible for any estate taxes when they receive the trust assets after the surviving spouse dies. 

Another benefit of an exemption trust is that before the surviving spouse passes away, they still retain several access rights to the trust assets during the remainder of their lifetime. For example, a surviving spouse can tap into both the trust’s income and its principal to pay for certain medical or educational expenses.

2017 Federal Tax Law Benefits Exemption Trusts 

The tax law passed by Congress in late 2017 raises the exemption limit for estate taxes. In fact, it doubles the cash value amount that couples can transfer without being subject to estate taxes. The prior exemption amount was just shy of $5.5 million per person. As a result of the tax reform, the exemption was increased to roughly $11.2 million for tax years 2018 through 2025.

Therefore, if the gross value of an exemption trust grantor’s estate is less than $11.2 million, when that individual dies, no estate taxes have to be paid. And even if the total value of the estate exceeds the $11.2 million limit, only the amount in excess of the exemption level is taxable. In other words, if an estate is worth $100,000 more than the exemption limit, only the $100,000 is taxed, rather than the $11.2 million. 

Example of an Exemption Trust

Exemption trusts often use an AB trust system in which two trusts, one belonging to each spouse, are funded roughly with 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 passed onto trust B and the excess beyond exemption limit (in this case, roughly $11.2 million), is funded into trust A to avoid federal estate taxes. The fund and its income are available to Krishnan during his lifetime. When he dies, $11.2 million (as defined by the federal exemption limit) from Trust A is passed on tax-free to his beneficiaries, utilizing Krishnan's exemption limit. The remaining amount is taxed. However, funds from trust B are passed on tax-free to the final beneficiary.