A testamentary trust is a trust produced by a will that a trustee will administer for the welfare of one or more beneficiaries who are named in the will. By definition, a testamentary trust will not come into existence until the death of the individual creating the will, the testator. Important steps in the establishment of a testamentary trust include determining the beneficiaries and trustees, establishing a will, choosing the structure of the testamentary trust, and structuring the language in the will to protect the trust from all potential legal and tax challenges after the death of the testator. It is essential for anyone desiring to set up a testamentary trust to meet with an attorney experienced in estate planning. Testators will also need to know what the federal estate tax laws allow for the unified credit in order to determine whether the value of total assets in the estate justifies a testamentary trust.
When making out a will, a testator may have a variety of reasons for setting up a testamentary trust. Most commonly, testamentary trusts offer a means for the testator to provide regular income and care for minor children or persons with disabilities after the testator's death. A testamentary trust also provides for the appointment of a responsible trustee for the assets, who will manage and supervise the disbursement of income and principal to the beneficiaries, make charitable donations, and preserve the assets for future distribution. By maximizing the use of the unified credit, testamentary trusts also reduce the impact of taxation to the estate value. If there is more than one beneficiary, the will should set up a separate testamentary trust for each beneficiary to ensure the lowest possible tax bracket for each coheir.
Testamentary trusts, also called bypass trusts, are particularly useful for married couples with joint estates that exceed the value of the allowed unified credit. For example, if the unified credit is $3 million US Dollars (USD), then each deceased partner may give $1.5 million USD tax-free to a trust. The surviving spouse still has unlimited access to the income generated by the trust, as well as access to the principal for expenses related to health, education, maintenance, and support (HEMS). If the spouse does not require the $1.5 million USD in the trust, however, the principal can pass to the beneficiaries exempt from taxation. When the spouse dies, an additional $1.5 million USD can be directed tax-free from the estate, presuming that the unified credit has not changed.
Alternatively, a testamentary trust can take the form of a bypass disclaimer trust. When a bypass disclaimer trust is established, the will gives all of the property to the surviving spouse, but the spouse, after assessing the economic picture, may disclaim or refuse some of the property within nine months of the death. Any declined assets then transfer into the bypass trust. In this way, the spouse has the flexibility to direct transfer of assets into the trust in accordance with the current financial picture. The bypass disclaimer trust also allows the spouse to adapt the funding of the trust to any changes in tax laws and unified credit amounts.