An exemption trust is an irrevocable trust that provides estate tax relief for wealthy married couples. When a couple initiates an exemption trust, the assets of the first spouse to die are passed not to the surviving spouse but to an irrevocable trust. In this way, the surviving spouse may use his or her federal estate tax exemption to avoid taxes while still having access to the funds within the trust.
Other advantages of this arrangement are that it protects the assets of the trust from second spouses or financial problems of the surviving spouse, helping to ensure that the wealth reaches the descendants of the deceased. Possible drawbacks for this kind of trust include the restrictions placed on the surviving spouse concerning its access and the fact that its terms may not be changed once one member of the couple dies.
In situations where estate planning has not been undertaken, when one member of a married couple dies, their wealth is automatically passed on to the surviving spouse. If the total wealth of the estate exceeds the maximum limit of the federal estate tax exemption, then the surviving spouse would be required to pay a hefty estate tax. Using an exemption trust is a way to circumvent this problem.
For example, a man and a wife have a combined $5,000,000 US Dollars (USD) in their estate. In normal circumstances, when the man dies, the wife would inherit the entire estate and, if the exemption level was at its 2008 level of $3.5 million USD, then the wife would have to pay taxes on 1.5 million USD at a high percentage rate. By using an exemption trust, the man's portion of the estate would be placed into a trust to which the wife would have access. Meanwhile, her portion of the estate, $2.5 million USD, would stay below the exemption level and therefore she would not have to pay taxes on it.
In addition to the tax relief, the surviving spouse would have some access to the principal amount in the trust for necessities such as health care or estate maintenance and also would receive any income generated by the trust. By putting the assets in a trust, the wealth of the estate is protected for future generations. Since it is not technically part of the surviving spouse's estate, the wealth cannot be touched by creditors, second spouses, or other unforeseen future circumstances.
There are drawbacks to this arrangement for the surviving spouse. When the first spouse dies, an exemption trust becomes irrevocable. This means that the surviving spouse has no remedy if the terms of the trust don't fulfill all of his or her financial needs. The surviving spouse, if he or she is named the trustee by the terms of the trust upon the death of the spouse, also has to be careful about granting himself or herself too much access to the principal within the trust. If that occurs, the assets may be considered part of the surviving spouse's estate, and then it will become subject to estate tax laws.