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Author: John Erik Fraker, Esq.

How a Living Trust Can Help You Disinherit Uncle Sam

Copyright © 2009 Ainer & Fraker, L.L.P.

A living trust can help you reduce your estate tax liability to Uncle Sam. To see how this tax reduction works, let’s examine the following hypothetical case:

Client Family has an estate of $4 million. The husband dies in 2006, leaving his entire estate to his Wife.

Under the 2006 tax rate, each spouse is entitled to an exemption of $2 million (known as Unified Credit Amount), which is not subject to Federal Estate Tax. Any amount over $2 million is subject to taxation at a rate up to a maximum of 46%.

According to the current law, here is the likely scenario without a Living Trust. The husband is able to transfer his entire estate to his wife, and pay no taxes at his death. This transfer is referred to as the Unlimited Marital Deduction, and it allows the husband, upon his death, to transfer any amount to his wife, free from estate tax.

That sounds like a pretty good deal, until you learn why Uncle Sam supports it. Uncle Sam knows that he is not giving up his right to collect the Estate Tax, but merely postponing it. By postponing it, Uncle Sam can collect a higher rate of taxes than he can by taking it immediately because both spouses did not use their exemption.

The husband has transferred his entire estate to his wife, and she now has an estate of $4 million. When the wife dies, Uncle Sam will allow her to use her $2 million tax exemption, but the remainder is taxed up to a maximum rate of 46%.

The result is that the wife will pay nearly $900,000 in estate tax on the $2 million of her estate that is not excluded from the estate tax.

Why will the wife have to pay nearly a million dollars in estate taxes?

Remember that the $2 million exclusion is allocated to each spouse. When the husband died, he did not use his exemption, and therefore, it was not available to help his wife upon her death.

The Unified Credit is a “use it or lose it” tax exemption. If you fail to use it at the first spouse’s death, it is gone forever. Fortunately, this outcome can be avoided through some basic estate planning.

Let’s examine what happens if Client Family has a Living Trust. At the husband’s death, $2 million passes outright to his wife in the Marital trust. $2 million passes to a Bypass Trust. In this scenario, both Unified Credit exemptions are used. The wife’s $2 million exemption is applied against the Marital trust, and her husband’s $2 million exemption is applied against the Bypass Trust.

The result?

Client Family passes on $4 million to their children, and the children pay no estate tax. For the price of a Living Trust, Client Family saved nearly a million dollars in estate taxes.

Which result do you prefer for your family?

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