The following is an example that is intended to illustrate how trusts can be used to save estate taxes for married couples:

Assumed Facts for Example

The easiest way to explain estate tax planning through the use of revocable trusts is by way of example. Assume that a married couple has a net worth of $7 million, with all assets owned by the husband alone. Assume further that the goal of the couple is to leave all assets for the benefit of the spouse at the first death and then at the death of the surviving spouse, all assets will pass to the couple’s children. Assume further that the 2008 U.S. estate tax exemption of $2 million is in place. Under the scenarios below, your husband will be deemed to have died on 1/1/08 and the wife on 6/1/08.

Scenario 1 --- Simple Wills

Let's assume that under the above facts, wife and husband have no trusts but have simple wills that provide that at the death of the first spouse, all assets pass to the survivor outright. On the death of the surviving spouse, all assets pass to the children. Assume husband dies 1/1/08 leaving all assets to wife. As long as wife is a U.S. Citizen, there is absolutely no estate tax due at husband's death when he leaves all assets to wife due to the fact that the IRS allows a deceased spouse to leave an unlimited amount of money to a surviving spouse without paying any estate tax. Assume wife dies on 6/1/08 at which time she now owns $7 million worth of assets (all of which she received from husband). She only has a $2 million federal estate tax exemption, which means that $5 million is subject to tax ($7 mill. - $2 million exemption = $5 million). For simplicity sake, assume that the estate tax rate is 50% . The estate tax owed upon wife's subsequent death would then be $2.5 million ($5 million x 50% rate = $2.5 million). The heirs would receive a net $4.5 million ($7 mill - 2.5 mill. tax = $4.5 million).

Note that the federal estate tax rate is 45% in 2008. The MA estate tax rate ranges from 5% to 10%, but the state estate tax paid is deductible from the federal gross estate. Rather than complicating the example with actual calculations, assuming a 50% blended rate will simplify the example. Note further that this example does not calculate state estate taxes specifically, the rules and exemptions for which vary from the federal estate tax.

Scenario 2 --- Husband Has Trust and Planned Assets Properly

Let's assume that under the above assumed facts, husband has a will that effectively provides that when he dies, all assets pass to his trust (rather than to wife outright). The trust contains a formula that directs the Trustee to set aside and hold in trust an amount equal to the estate tax exemption amount (currently $2 million). Any assets above & beyond the exemption amount should pass to wife outright. At husband's first death, per the formula described above, $2 million is set aside and held in trust by the Trustee (i.e., it is equal to the estate tax exemption amount) and the remaining $5 million passes outright to wife. The $5 million passing to wife is not subject to estate tax because the assets pass to a spouse. The $2 million held in trust is NOT taxed since the assets do not exceed husband's estate tax exemption amount. What are the rules of the $2 million trust? Wife receives all income, she can get principal for her support etc. She has limitations on her access to the principal such that distributions can only be made for her health, maintenance, medical care, support. For example, she cannot take out $100k to spend at Mohegan Sun. By placing limits on wife's access to the $2 million held in trust, when wife subsequently dies on 6/1/08, the $2 million in husband's trust is NOT considered by the IRS to be her money and is NOT taxed in her estate. Therefore, wife is only taxed on the assets in her name, which is the $5 million. Wife has a $2 million exemption, so she is only taxed on $3 million ($5 mill - $2 mill = $3 mill), which results in estate taxes of $1.5 mill assuming a 50% rate ($3 mill x 50% = $1.5 million). The kids in this scenario net $5.5 million ($7 mill - $1.5 mill. estate tax = $5.5 million). That results in a $1 million savings over Scenario 1. What is the primary difference here? In Scenario 1, the couple had the opportunity to each use their $2 million exemption, but husband did not take advantage of his exemption at all because he left all of his money to wife. Therefore, he used NONE of his exemption and the couples’ combined estates were all taxed in wife's estate such that they only had the opportunity to use one person's $2 million exemption to offset the $7 million estate. With Scenario 2, husband at his first death used 100% of his exemption by holding $ 2 million in trust and NOT paying it over to wife. Wife then fully used her exemption with the remaining assets at her subsequent death such that the couple was able to use their combined exemption potential of $4 million to offset the $7 million estate. In contrast, in Scenario 1, only $2 million of the possible $4 million combined exemption was used. Note that there is typically nothing that can be done with Scenario 1 after the death of the first spouse to fix that result.