Setting up a trust is a valuable tool when planning for your family's financial future. A trust can hold a wide variety of assets, and as the grantor you can name the beneficiaries who inherit these assets after your death. A trust avoids probate court, making life simpler for the beneficiaries. However, federal and state estate taxes remain a consideration -- trust assets are not exempt. Researching the rules of the IRS and the state in which you live is especially important as tax law concerning estates changes frequently.
The federal estate tax changes regularly as Congress revises the tax code. By a new law passed in 2010, for example, the IRS exempted the first $5 million of assets from estate taxes beginning in the tax year 2011. Any assets over this amount were taxed at the rate of 35 percent. The IRS counts trust assets for purposes of the estate tax, whether the trust is revocable or irrevocable. For the tax year beginning January 1, 2012, Congress indexed the estate tax exemption to the rate of inflation, raising it to $5.12 million.
For married couples, one important feature of the new estate tax law was "portability" of the exemption from one spouse to the other. If a husband or wife died in 2011, the estate tax exemption of $5 million applied to that individual. With estates worth less than $5 million, any unused portion of the exemption passed to the surviving spouse. Therefore, a trust in the name of one spouse that contained $3 million in assets passed $2 million in additional exemptions to the surviving spouse upon the death of the first trust grantor. In order to claim this additional exemption, the surviving spouse must file IRS Form 706, the Estate Tax Return.
Many states have their own estate taxes, and none of them allow one spouse to claim the unused exemption due to the other spouse. In addition, some states allow an even smaller exemption than the federal law does. In Minnesota, for example, the estate tax exemption is only $1 million. A few states levy an inheritance tax on anyone who benefits from a transfer of estate assets. The beneficiary, not the estate, is responsible for paying the tax; several states set low or no inheritance tax on spouses or immediate family.
One popular method of protecting assets from estate taxes is to place the exemption amount -- whatever it may be this year -- into a trust with the other spouse as a beneficiary. When the trust grantor dies, that amount passes to the survivor, who does not have to include the assets in their own estate for tax purposes. "Portability" of the estate tax exemption, however, does away with this method. If one spouse can claim a part of the other's exemption, then any trust assets given to a surviving spouse are counted as estate assets.