When people begin the process of estate planning, a subject often of primary importance is protecting the estate’s assets from taxes, particularly if the estate is large. In the United States, the federal estate tax is considered by many to be an inheritance tax, and there is an estate value ceiling above which a hefty tax is imposed when the estate’s owner dies. An estate may pass from one spouse to another without taxation, as long as the spouse is a U.S. citizen, but the surviving spouse’s heirs will have to pay the tax upon the second spouse’s death. It is possible, however, to avoid estate taxes — at least to a significant degree — through the establishment of a trust.
Estate and inheritance taxes are those from which large estates most often seek relief. Although the two terms are often used interchangeably, the difference between them is basically that estate taxes are paid by the estate of the deceased, while inheritance taxes are paid by those who inherit the wealth of the deceased. There are estate tax laws at the federal level and inheritance and estate tax laws at the state level, where there is quite a bit of variability.
The U.S. Tax Relief Act of 2010 raised the value of the federal estate tax ceiling to $5 million US Dollars (USD), with an effective tax rate of 35 percent. This means anything in an estate over the $5 million USD cap would be taxed at 35 percent unless going to a spouse. It is this over-the-cap amount that those with large estates wish to shield from inheritance tax with a trust.
Avoiding inheritance tax with a trust effectively transfers estate funds to heirs without subjecting them to inheritance tax. For tax years 2011 and 2012, married people in the U.S. will be able to meld their individual $5 million USD gift-tax exemptions to transfer up to $10 million USD to their heirs, tax free. Such exemptions can change, however, so those planning their estates may look to protect their assets and decrease inheritance tax with a trust known as an AB trust.
The "A" portion of an AB trust is commonly called the "marital" portion of the trust; the "B" part is known as the "bypass" or "family" portion. These trusts can be set up via a will or a revocable living trust. This type of trust allows the combining of the spouses’ two exemptions and, when one spouse dies, allows the surviving spouse to use money from the trust for living expenses. When the second spouse dies, the large exemption amount means that, for all but the very largest of estates, the heirs will pay either no or very little estate tax.
Inheritance taxes, levied by individual states, are a different matter. As of 2011, seven U.S. states collected an inheritance tax, which varied from approximately 1 percent to 20 percent of the estate's value. All seven states exempt spouses from this tax, and four exempt children and grandchildren, as well. It is usually not possible to avoid paying this inheritance tax with a trust, so some people put language in a will that directs the estate to pay any inheritance taxes for which the heirs might be responsible.