Marital Deduction and Utilizing the Unified Credit
When a decedent dies, an estate tax will be due on the value of their estate that exceeds the unified credit for the year of death. Federal tax law provides for an unlimited marital deduction between married couples (not available to domestic partners and restrictions apply to non-US citizen spouses). This means that a decedent's property passing to his surviving spouse will not be subject to estate tax to the extent a marital deduction is claimed which can effectively defer payment of any estate tax until the death of the surviving spouse. However, any property from the decedent's estate for which the marital deduction is claimed will be included in the surviving spouse's estate and may be subject to estate tax if the surviving spouse still owns the property at her death. The marital deduction is also available to lifetime gifts between spouses.
Preserving the Decedent's Unified Credit (see Tax, Portability and Exemption Planning for 2010, 2011 and 2012)
Good estate tax planning involves utilizing as fully as possible each spouse's exemption equivalent (see Federal Transfer Tax). To accomplish this, the estate plan for a married couple would be designed to include provisions that would preserve the decedent's unified credit by providing for a sub-trust to be created at the death of the first spouse. This trust would be funded with assets equaling the amount representing the unified credit available for that year. The trust may provide the surviving spouse with certain rights during his or her life without causing the trust to become part of the surviving spouse's estate for estate tax purposes. The surviving spouse can serve as trustee of this trust, receive all of the trust's net income, and receive principal if necessary for his or her maintenance, support, education and medical care and the surviving spouse may have the non-cumulative right to withdraw the greater of 5 percent or $5,000 of trust principal per calendar year for any reason ("5&5 power").
These trusts go by many names the most common being either "exemption trust", a "credit shelter trust" or a "by-pass trust" since it is exempt from estate taxes, shelters the unified credit and by-passes taxation in the surviving spouse's estate.EXAMPLES ASSUMING IT IS 2013
Let's say it is 2013 and John and Mary, both US citizens are married with one child, Bobby, and live in California. Let's also assume that their combined estate, consisting 100% of community property is valued at $2 million on February 22, 2013, the date of John's death. John and Mary had always talked about seeing an estate planning attorney but never got around to it. By the laws of intestacy of California, Mary, as John's spouse, inherits John's ½ share of the community property ($1 million). All $2 million of the estate value is now owned solely by Mary.
It is 2013 and the unified credit amount is $1 million. John's interest in the community estate is $1 million. Even though John had a taxable estate, by virtue of the marital deduction, all of John's property will pass to Mary and completely escape estate taxation at John's death. However, Mary's estate is now worth $2 million which is $1 million more than the exemption exclusion amount for 2013. Let's say Mary dies later in the same year. Mary's estate uses her $1 million applicable exemption exclusion for 2013. That leaves $1 million subject to the 55% estate tax to be paid before the property passes to Bobby. Instead of Bobby receiving a $2 million inheritance from his parents, he will receive $1.45 million after payment of the estate tax liability of $550,000. This is a $500,000 estate tax bill that could have been completely eliminated with basic advance planning. ($1 million times 55% = $550,000 = estate tax liability: $1 million - $550,000 = $1.4 million = inheritance).
Adding insult to injury, if Mary neglected to do her own estate planning for her property, Bobby would be forced to have the property transferred to him through a time consuming, public probate proceeding incurring even more costs.
Here we will assume that at the beginning of 2013, John and Mary draft an estate plan. The plan providing that the unified credit exemption equivalent available in the estate of the first spouse to die would be transferred to a Bypass/Credit Shelter Trust for the benefit of the surviving spouse with Bobby as the remainder beneficiary. With our facts, when John died, a marital deduction was claimed and his estate escaped estate taxation. John's exclusion exemption, $1 million for 2011, was placed in a Bypass/Credit Shelter Trust for the benefit of Mary. When Mary passes away later in the year, her estate will use her $1 million exemption exclusion for her estate, and because the $1 million in the Bypass/Credit Shelter Trust will not be included in Mary's estate, the plan has eliminated the estate tax liability completely. In this scenario, the tax liability will be zero and Bobby will receive the entire $2 million inheritance.
The applicable unified credit exemption amount (credit shelter bequest) can be left to beneficiaries either outright or in trust. How any bequest is left to your beneficiaries depends on a number of factors including the beneficiary's ages and their ability to handle money. Passing assets to your heirs in a trust can provide for protection against the beneficiary's own excesses as well as provide asset protection from creditors and asset protection in the event of divorce.
If the surviving spouse's estate will not exceed the applicable exclusion amount and thereby avoid estate tax, this type of planning is not necessary. That being said, it is difficult to gauge what you might own at the time of your death or how your current assets will appreciate or depreciate. Additionally, the estate tax law and attendant exemption exclusion rules are in flux and subject to change over the next several years. For more flexibility and discretion during uncertain times, the couple's estate plan could be set up directing the Bypass Trust to be funded with property disclaimed by the surviving spouse (see Planning Using Disclaimers).
While domestic partners are not eligible for the marital deduction, the use of a Bypass Trust may be considered useful to benefit the surviving partner by not causing the trust property to be taxed in the surviving partner's estate.
Competent estate planning is especially crucial in estates where there is considerable wealth. The above is a basic example of a commonly used estate planning technique aimed at limiting transfer taxes. For larger estates, there are many planning devices available to protect your assets, reduce taxes and transfer wealth to your beneficiaries (see Irrevocable Trusts).