If a married couple has an estate plan by which all of their combined net estate will pass to the surviving spouse, this may result in what we refer to as the Marital Deduction Trap.
Consider the following example. Let's assume Harry and Wanda have a combined net estate with a value of $1,350,000 Let's also assume that Harry dies and all of his property passes to Wanda, either under Harry's Will, because the property was owned by them as joint tenants with rights of survivorship, or by reason of beneficiary designations naming Wanda as Harry's beneficiary.
At Harry's death, there will be no estate taxes due because all of his property passed tax-free by reason of the unlimited marital deduction. However, when Wanda dies, she will have an estate of $1,350,000 (or whatever it has appreciated to between Harry's death and Wanda's death). Even if we assume Wanda has not used any of her Applicable Exclusion Amount by making lifetime gifts, she will be able to pass only $675,000 of her estate free of estate taxes (assuming Wanda died in 2000). The property in her estate in excess of $675,000 will be taxed at a rate starting at 37%. In other words, Wanda's estate will still owe estate taxes of $270,750 at her death. This is a Marital Deduction Trap because, by allowing all of his property to pass outright to Wanda, Harry did not use any of his Applicable Exclusion Amount.
One way for Harry to have used his Applicable Exclusion Amount would be for him to make a Will leaving one-half of his and Wanda's net worth ($675,000) to their children, outright. Then, when Wanda dies, her estate would be worth only $675,000, all of which could pass tax free because of her Applicable Exclusion Amount.
Although this may result in the desired tax savings, it may not be palatable to most couples. Wanda may protest, "Not only did I just lose my husband, I also lost one-half of our earning potential and one-half of my net worth." Such spousal impoverishment may not be wise. In order to avoid the outright gift to the children upon the death of the first spouse, yet still make it possible to utilize the Applicable Exclusion Amount of the first spouse to die, Harry and Wanda can put into place what we refer to as "Credit Shelter Planning using a By-Pass Trust Arrangement" (a.k.a. "A/B Trust Arrangement" or "Credit Shelter Trust Arrangement").
Instead of leaving all of their estate to one another, and incurring estate taxes of $270,750 upon the death of the second spouse to die, Harry and Wanda may put into place the following estate plan.
First, Harry and Wanda each put into place a will that requires the estate of the first spouse to die to be divided into two separate shares, the "Family Share" and the "Marital Share." The Family Share will have allocated to it the maximum amount of property which the decedent may transfer free of estate tax after taking into consideration his unified credit - i.e., the Applicable Exclusion Amount. (See article entitled UNIFIED GIFT AND ESTATE TAX SYSTEM). The Marital Share will have allocated to it the remainder of the decedent's estate.
Harry's and Wanda's wills then provide that the Family Share shall be held in trust, the "Family Trust", for the benefit of the surviving spouse. The Family Trust may pay all income earned by the trust to the surviving spouse, for life. The Family Trust may also permit the Trustee of the trust to distribute trust principal (the initial amount allocated to the trust and all appreciation of same) to or for the benefit of the surviving spouse, as necessary for the surviving spouse's health, maintenance and support. Finally, the Family Trust may provide that the surviving spouse shall act as Trustee of the trust. Harry's and Wanda's wills also provide that the Marital Share shall be distributed to the surviving spouse, outright and free of trust.
Harry and Wanda then divide their assets as evenly as possible so that they each have, in their respective names alone or ready to pay-over to their probate estate at death, assets worth as close to $675,000 as possible. This will insure that, regardless of which of them is the first to die, the Family Trust created under the will of the first spouse to die will be fully funded.
At Harry's death, his half of their net worth up to $675,000 passes to a "Family Trust" created under Harry's Will. Any assets in Harry's estate in excess of $675,000 (the "Marital Share") pass outright to Wanda. Wanda acts as Trustee of the Family Trust. The Family Trust pays income to Wanda for life, and the Trustee of the Family Trust (who may be Wanda) may invade the principal of the Trust if necessary for Wanda's health, support or maintenance. At Harry's death, no estate taxes are owed because the Family Trust passes tax-free because of Harry's unified credit and the Marital Share passes tax-free because of the unlimited marital deduction.
At Wanda's death, the Family Trust created upon Harry's death is not considered part of Wanda's estate for estate tax purposes. This is true even though Wanda had control of the property of the trust, she received all of the income of the trust and she was entitled to the principal of the trust for her health support and maintenance. After Wanda's death, the Family Trust that was created upon Harry's death is also paid to Harry and Wanda's children.
Wanda will have a taxable estate of only $675,000 (the assets in her name alone, plus the Marital Share distributed to her from Harry's estate at Harry's death, if any). Because of Wanda's Applicable Exclusion Amount, she may pass this amount tax-free to her and Harry's children. Ultimately, Harry and Wanda's children receive the full $1,350,000 estate of their parents essentially free of estate and gift taxes!!!
The amounts passing to Harry and Wanda's children, either from the Family Trust or from Wanda's estate, may pass to them in further trust or outright, depending upon what Harry and Wanda believe is in the best interest of their children. For example, the further trust may distribute to a child his or her share one-third at age 25, one-third at age 30, and one-third at age 35.
Further, if the wealth of Harry and Wanda is primarily attributable to one of them, and if the more-monied spouse would rather not place assets in the other spouse's name alone, another planning technique is available known as a Qualified Terminable Interest in Property Trust ("QTIP Trust"). Under a QTIP trust, the same favorable estate tax results might be achieved, as in the example above, but the property does not have to be equalized between the spouses.
Compare how Harry and Wanda's combined net worth will pass where they do not put into place Credit Shelter Planning and where Credit Shelter Planning is used:
- $1,350,000 ESTATE
- All to Surviving Spouse
- All Passes Tax-Free because of Unlimited Marital Deduction
- Tax Due at Death of First Spouse = 0
- Surviving Spouse's Estate is Valued at $1,350,000
- Tax Payable at Death of Surviving Spouse: $270,750
- Heirs Receive $1,079,250
- NO CREDIT SHELTER PLAN
- $675,000 to Surviving Spouse
- All Passes Tax-Free because of Unlimited Marital Deduction
- Tax Due at Death of First Spouse = $0
- $675,000 Passes Tax-Free because of Surviving Spouse's Applicable Exemption Amount. $675,000 Excess is Taxed.
- Tax Payable at Death of Surviving Spouse: $0
- CREDIT SHELTER PLAN USED
- $675,000 to By-Pass Trust (a.k.a. Family Trust)
- All Passes Tax-Free because of Applicable Exclusion Amount Available to First Spouse to Die
- Tax Due at Death of First Spouse = $0
- Surviving Spouse's Estate is Valued at $675,000. Entire Estate Passes Tax-Free because of Surviving Spouse's Applicable Exclusion Amount
- Tax Payable at Death of Surviving Spouse: $0
- Heirs Receive $675,000 from Estate of Surviving Spouse. Heirs Receive $675,000 from By-Pass Trust of First Spouse to Die