Exemption Trusts

An exemption trust is any trust structure designed to take full advantage of a deceased person's estate and gift tax applicable exclusion amount, preventing that exemption from being wasted when assets pass to a surviving spouse. The most common version is the credit shelter trust, also called a bypass trust or A/B trust. Assets up to the exemption amount fund the trust at the first spouse's death. Those assets and all future appreciation stay permanently outside the surviving spouse's taxable estate. The surviving spouse benefits from the trust during their lifetime without owning it.

The 2025 federal estate tax exemption is $13,990,000 per individual. A married couple using an exemption trust correctly can shelter up to $27,980,000 from federal estate tax across both deaths.

Why Exemption Trusts Exist When Portability Is Available

Portability, enacted in 2010, lets a surviving spouse inherit the deceased spouse's unused exemption by filing a timely estate tax return. This seems to make exemption trusts redundant. In some situations, it does. But four planning advantages keep exemption trusts relevant even in the portability era.

• Future appreciation protection: Assets inside an exemption trust grow outside the taxable estate. Portability transfers a fixed dollar exemption; it does not shelter future growth on assets themselves.
• GST exemption is not portable: The generation-skipping transfer tax exemption cannot be transferred to a surviving spouse. An exemption trust can be funded with the deceased spouse's GST exemption, creating a multigenerational tax-free transfer vehicle.
• State estate taxes: Most states with their own estate tax do not honor portability. An exemption trust can hold assets up to the lower state exemption, shielding them from state tax that portability would not protect against.
• Remarriage and blended families: An exemption trust guarantees that assets ultimately pass to the first spouse's children rather than to a new spouse's family after the surviving spouse remarries.

How an Exemption Trust Is Funded

The trust does not exist in any meaningful form during both spouses' lifetimes. It is created in the will or revocable living trust but only activates and receives assets when the first spouse dies. The executor funds the trust with assets equal to the deceased spouse's remaining exemption, typically by transferring specific assets or a fractional share of the estate.

Funding decisions matter. The executor should consider which assets have the highest growth potential for transfer into the trust, and which are better suited for the surviving spouse's direct ownership, where a step-up in basis at the second death would apply.

The 2025 Sunset Makes This Planning Urgent

The elevated exemption of $13,990,000 per person is scheduled to expire after December 31, 2025 under the Tax Cuts and Jobs Act. Without congressional action, it falls to approximately $7,000,000 per person, adjusted for inflation, starting January 1, 2026. Couples whose combined estates could potentially exceed $14,000,000 in the future should review whether an exemption trust structure is properly drafted and funded before the sunset takes effect.

Sources

• https://www.irs.gov/newsroom/irs-releases-tax-inflation-adjustments-for-tax-year-2025
• https://www.law.cornell.edu/uscode/text/26/2010
• https://www.fidelity.com/viewpoints/wealth-management/insights/credit-shelter-trusts