A "Bypass Trust", also known as a "Credit Shelter Trust", is a common type of Trust married couples include in their Wills or Revocable Living Trust to reduce or even eliminate state and federal estate taxes.
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Tax Threshold
Estate taxes for both the United States government and the State of Washington apply to taxable estates with a value that exceeds a certain threshold amount. For federal estate taxes, the filing threshold will vary over the next three years, as follows: 2009: $3,500,000 ; 2010: No Estate Tax;
2011 and beyond: $1,000,000 . Because assets below this filing threshold are not taxable, these amounts are also referred to as the "exclusion amount". For the State of Washington, the exclusion amount is $2,000,000, with substantial additional deductions available for qualified farmland and farming equipment.
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State and Federal Tax Planning
For both state and federal tax purposes, there is an unlimited deduction available for property transferred to a spouse (unless either spouse is not a US citizen). A decedent may leave an unlimited amount of assets to his or her surviving spouse, tax free, without relying on the state or federal exclusion amounts referenced above. However, this can result in unnecessary estate taxes being due on the estate of the second spouse to die. To reduce or eliminate this tax liability, and potentially double the amount that may pass tax free to their heirs, couples can combine the exclusion amounts applicable to their respective estates by incorporating a Bypass Trust into their Wills or Revocable Living Trust. Upon the death of the first spouse, the Bypass Trust is created for the benefit of the surviving spouse, and may be funded with assets up to the highest applicable state or federal exclusion amount.
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How the Bypass Trust Works
Let’s assume a married couple has an estate worth $2 million. The husband dies in 2009, leaving his half of the marital estate ($1 million) directly to his wife. The wife dies in 2011, with an estate worth $2 million; no Washington estate tax would be due, but after applying the federal exclusion amount of $1 million, federal estate tax would be due on the other $1 million in the wife’s estate. Had the husband created a Bypass Trust for the wife’s benefit, he would have used his exclusion amount by placing $1 million in a bypass trust, keeping those assets out of his wife’s estate, thereby reducing her taxable estate to $1 million and completely avoiding both state and federal estate taxes.
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Upon the Death of the Surviving Spouse
Upon the death of the surviving spouse, the remaining Trust assets pass directly to contingent beneficiaries, such as children or grandchildren, potentially tax free; some tax may be due because the exclusion amounts for state and federal tax purposes are not the same. For example, in 2009, the Washington exclusion amount is $2 million while the federal exclusion amount is $3.5 million. The estate of a decedent dying in 2009 would be permitted to fund a credit shelter trust with up to $3.5 million in assets; for Washington estate tax purposes, an election could be made to defer any Washington estate tax due on the $1.5 million difference until after the death of the surviving spouse, by making what is known as a QTIP election. Moreover, the state would only impose a tax on that portion of the assets remaining after the death of the surviving spouse.
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Qualified Domestic Trust
A Qualified Domestic Trust (QDOT)is a tax-planning trust available to married couples when either spouse is not a US citizen, and is used because the unlimited marital deduction is unavailable if the surviving spouse is not a US citizen. Without a QDOT, if the surviving spouse is not a US citizen, the estate of the first spouse to die will have to pay estate tax if the taxable estate exceeds the applicable state or federal exclusion amounts. However, if assets in excess of the exclusion amount are placed in a QDOT, the tax on these assets will be deferred. A QDOT may be used to defer both state and federal estate taxes.
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