Exemption trusts (also called a bypass trust, AB trust, or a credit shelter trust) are a tool used by well-off married individuals to legally maximize their estate tax exemptions.

The strategy involves creating a trust or two separate trusts after one spouse passes. Usually, the deceased spouse’s portion of the couple’s property, at least up to the applicable exclusion amount ($12.06 million in 2022 for individuals), is put into a trust (the exemption trust). This trust is irrevocable and will pass to the beneficiaries other than the surviving spouse (usually their children). The surviving spouse must follow the trust’s plan without overly benefiting from its operation, but this trust often passes income to the surviving spouse to live on for the rest of their life. The surviving spouse’s portion of the property and sometimes the leftover assets of the deceased spouse above the exclusion amount will be put into another trust or simply left to the estate of the surviving spouse. When the surviving spouse passes, the exemption trust passes to its beneficiaries, and the assets of the surviving spouse, whether or not in a trust, will avoid estate taxes up to their own exemption amount. This means that the exemption trust assets do not take up any of the surviving spouse’s exemption.

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This method of dividing assets may save on estate taxes, but only in limited circumstances. Before the Tax Cuts and Jobs Act, many individuals used this to take full advantage of their estate tax exclusions which were less than $6 million. After the Tax Cuts and Jobs Act, this tool can only be beneficial in limited circumstances because the exclusion now is over $11 million which applies to few individuals. Further, now a spouse’s exclusion is portable, meaning a deceased spouse’s exclusion can be used by the surviving spouse, and this eliminates many of the benefits of an exemption trust. However, many states have no gift taxes or have estate taxes which are not portable, which might make exemption trusts still beneficial to wealthy couples.

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One must be careful when using exemption trusts and should seek advice from estate experts. The Internal Revenue Service (IRS) requires specific wording in the creation of these trusts and limits on the surviving spouse’s use of the exemption trust. Also, given the high fees involved in planning, managing, and paying for attorney fees for exemption trusts, often an exemption trust may be more costly than the estate tax itself, and sometimes, the estate would incur less taxes outside of the exemption trust by incurring a stepped-up tax basis for property.

[Last updated in February of 2022 by the Wex Definitions Team]

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