I. FEDERAL ESTATE TAX

The federal estate tax is a death tax imposed on the value of everything that you own (your "assets") at the time of your death.  It can be an extremely onerous tax, reaching as high as 55% of the value of the assets which you hold.  As a result, for individuals with larger estates, a great deal of planning is directed towards reducing or eliminating, to the extent possible, the application of the federal estate tax.

There are two principal exceptions to the application of the federal estate tax to the value of assets which you own at the time of death.  The first one is referred to as the exemption equivalent amount (and used to be called the unified credit).  This is the maximum amount that could be transferred, either during your lifetime or at the time of death, without the imposition of a transfer tax (either the estate tax on the gift tax).  For 2000 this amount is $675,000, but it increases over the next several years based on the following schedule:

  Year                            Amount
   2000 and 2001            $675,000
   2002 and 2003            $700,000
   2004                          $850,000   
   2005                          $950,000   
   2006 and thereafter      $1,000,000

As a result of the foregoing, if the total value of your estate is significantly below the exemption amount, you may not need to be concerned with planning to avoid federal estate taxes.  If the value of your estate falls somewhat below or in excess of these amounts, estate tax planning should be a significant element in your personal plan.  Even if the total value of your estate is below this amount presently, the fact that your estate may grow in the future may cause you to carefully consider the planning alternatives available.

The second major exception to the application of the federal estate tax is the marital deduction.  This exception generally provides that anything that you leave to a spouse (meaning a member of the opposite sex with whom you are lawfully married), regardless of its value, will be free of estate tax.  These two rules interact to form the core of what is used in most estate planning.  This is referred to as the "A-B" trust plan or the "bypass" trust plan.  The basic concept is rather simple, but is perhaps best illustrated by a brief numerical example.

Assume that in a community property estate my wife and I have an estate with a value of $2,000,000.  If I use the simplest plan and simply leave property to my wife, at the time of my death, no federal estate tax will be paid because all of my property is being distributed to my wife.  This is the "marital deduction" at work.  At the time of my wife’s death, if she dies in the year 2000, $675,000 will be exempt from the estate tax.  However, the remaining $1,325,000 will be subject to an estate tax and around 40% of that amount is likely to go to the Internal Revenue Service rather than to my children. 

A more sophisticated plan would indicate that at the time of my death, I would leave an amount equal to $675,000 to my children, with the balance being distributed to my wife.  I would still pay no federal estate tax because I have used the exemption equivalent of $675,000 for the amount going to my children, and the marital deduction for the amount going to my wife.  If my wife then dies in the year 2000, she will have her own $675,000 exemption.  Because both my wife and I had each used a $675,000 exemption, a total of $1,350,000 would be transferred to our children tax free, and a tax would be imposed, at my wife’s death, on the remaining balance of $650,000.  As a result, our children would receive substantially more and the IRS substantially less.

Obviously, it would also be good planning for both of us to continue to survive the dates set forth in the chart above to increase in the existing exemption.  Using the same plan, if my wife and I both were to die in 2006, no federal estate tax would be paid.  Thus, from a tax planning perspective, longevity is beneficial.

The foregoing is obviously a simplified example of how the bypass trust operates, but serves to give you a reasonable idea of why it becomes so important.

Many clients are concerned about the possibility of leaving $675,000 to the children at the date of death of the first spouse.  After all, in many personal plans, the livelihood and care of the surviving spouse is placed ahead of the provision for the children.  This is frequently resolved by leaving the $675,000 exemption equivalent amount for the benefit of the children at the first spouse’s death into a trust.  In that trust, often called the "Bypass Trust," we can name the surviving spouse as the trustee (who manages the property), as the person entitled to receive all income from the trust, and, under certain limited circumstances, can provide the spouse access to the principal of the trust for basic health, support and maintenance.  The inclusion of these provisions, which for many practical purposes gives the surviving spouse control of the exemption equivalent amount, is respected by the Internal Revenue Service and operates effectively in the manner described above as an effective "Bypass Trust."

As you can see, the discussion of "trust" in this context involves concepts quite different from the use of a Revocable Living Trust, described at "THE USE OF A REVOCABLE LIVING TRUST." The "Bypass Trust" described here, is created only after the death of the first spouse, and is a specifically crafted trust designed to assure that it will qualify for the tax treatment contemplated.  You should be cautious not to confuse the concept of the Revocable Living Trust, which is intended to avoid probate, with the "Bypass Trust," which is a different type of trust created to minimize the application of the federal estate tax.