The wealth that you have accumulated over your life was the product of hard work and sacrifice. You probably would prefer that, after you die, your wealth pass to your loved ones and the institutions you care most about and not to the federal government or your state legislature. Estate tax planning can soften the sting of the estate tax if not eliminate it altogether.

What is the Estate Tax?

The estate tax is a tax on a person's assets after death. What exactly counts as "your estate" is a tricky question in itself that an attorney can answer for you, but roughly speaking it includes cash, securities, real estate, life insurance proceeds, trusts, annuities, business interests and other assets. For an individual, 11.7 million—soon to be 12.6 million—can be excluded, meaning that no tax is paid on that amount at all. For a married person, that amount is double those figures (more on how this is achieved below). Any amount above that is subject to a tax by the federal government. The first 1 million dollars in excess of that amount is subject to varying rates of taxation, but everything above that is taxed at a steep rate of 40 percent.

Example: You and your spouse have an estate that is 10 million dollars in excess of the exemption amount. Upon both of your deaths, if you take no estate planning measures, either your estate or your heirs will pay roughly 4 million dollars of that to the government.

Deductions, Exclusions, and the Marital Deduction

Much of estate planning, and tax law in general, requires a foundation in tax law and tax law concepts. While it is your attorney's job to be knowledgeable in these areas, this is a very basic overview of two key concepts that will come into play as we look at marital deduction planning.

A deduction allows you to subtract the amount of said deduction from your taxable income to lower the amount of taxes you owe. The marital deduction amount (more on this below) is unlimited and it allows you to subtract an unlimited amount from the estate tax you would otherwise owe. What it does not do, however, is wipe away the possibility of tax on the estate forever. Because the surviving spouse cannot use the deduction when they die and leave it to their heirs, at that time the tax will become due. A deduction is therefore not a tax avoidance method, but a tax deferral method. Tax deferral is still a powerful tool because money tends to grow in value over time, and it is better to pay tax later than sooner so as to maximize that growth.

An exemption, on the other hand, allows you to exclude income from taxation by the government. In other words, the IRS will pretend it does not exist, and will therefore not tax it at all. An exemption frees money from tax at any time, and is therefore favorable to a deduction.

The marital deduction—as we have discussed—allows spouses to transfer an unlimited amount of money to one another tax free, including upon death. That amount which is gifted to the surviving spouse upon death and qualifies for the marital deduction is called the "marital share." However, the gift to the surviving spouse will only qualify for the marital deduction when it takes the form of an outright gift or a qualifying interest in a trust. In order to be such a qualifying interest, the gift must be structured in a certain way such that the property is included in the surviving spouses estate when he or she later dies. A so-called, "terminable interest," or one that will one day expire on the happening of an event, may not qualify for the deduction. Only specific terminable interests will qualify.

Of course, a simple outright gift to one's spouse will qualify, but creating a gift that is terminable yet also deductible is an effective estate planning method that combines the tax savings of the marital deduction along with the control, confidence in desired distributions, and administrative ease of a trust. For more on these options, read our blog post titled: "3 Ways to Distribute the Marital Share."

How Can I Plan my Estate to Pay Less or None of the Estate Tax?

Prior to 2012, this was a much more complicated answer. That was until congress passed the American Taxpayer Relief Act. That act allowed a married person to take his or exemption amount that he or she did not use and pass it over to their spouse upon their death. This, in conjunction with the unlimited marital deduction, allows for a much higher estate tax exemption upon the death of the surviving spouse.

Example 1: Adam and Beatrice are married. They each own approximately 11.7 million dollars in assets (collectively amounting to 23.4 million dollars). Adam dies and leaves everything to Beatrice. Due to the unlimited marital deduction which allows an individual to transfer an unrestricted amount of assets to their spouse at any time—including on death—free from tax, Adam is able to avoid the estate tax without even needing to use the exemption amount. By filing an estate tax return and making an election for portability, he can "give" his unused exclusion amount of 11.7 million to Beatrice. When Beatrice dies, she has her own 11.7 million dollar exclusion amount and Adams that he passed to her, combined for an exemption amount of 22.4 million dollars. They now only owe tax on the remaining 2.6 million. An overwhelming tax savings as opposed to if they had not made the portability election.

What is a Bypass Trust and How Does Portability Affect it?

You may have heard of a bypass trust (also called a credit shelter trust). It is less applicable after portability was made available in 2012, but it still has its uses. To illustrate why portability made the bypass trust less of an essential tool than it once was, let's look at another illustration.

Example 2: Assume the same facts as above with our married couple, Adam and Beatrice, except this time assume there is no portability. Now when Adam dies and leaves Beatrice everything, she has only 11.7 million dollars to use as an estate tax exemption against her 25 million dollar estate. Adam cannot give her his exemption to add to hers. Her estate is now on the hook for roughly 13 million dollars, 40 percent of which will go to the IRS.

But wait, because where there is a wills and trusts attorney, there is a way! Adam could leave his property of 11.7 million dollars not to Beatrice, but to a trust for Beatrice's benefit. The trust can be drafted in such a way that restricts her access to funds, but still provides her with income and even distributions for her lifestyle needs. Such a trust will not be included in her estate if she passes away, nor would it be included in Adam's estate either. He would not owe tax on it because—while he did not get the marital deduction by passing it to Beatrice, his exemption eliminated his tax liability. On Beatrice's death, her estate has the remaining 13 million dollars it had in the first example. Her estate gets her 11.7 million dollar exemption and pays taxes on only the remaining amount.

In the current age of portability, such a trust is often not necessary for estate tax savings. Nevertheless, it is important to illustrate it for a couple of reasons. First, the laws could—and probably at some point will—change and second because the bypass trust has other uses which we will discuss below. Do note that the main advantages of a revocable trust—namely probate avoidance, private administration, and control over distribution after one's death—are not any less present due to these rules on portability: all of those advantages exist regardless of your asset level.

When a Bypass Trust Still Should be Used

1) Tax Avoidance (Even with Portability)

The first reason for utilizing bypass trust in an estate plan what we will cover is for tax reasons (even with portability), but for most clients, the value of a bypass trust will come for reasons entirely unrelated to tax. In the event ones estate exceeds the exemption amount—or there is a reasonable anticipation that it will grow well beyond that amount—the tax-related bypass trust is still very useful.

Example 3: Recall Adam and Beatrice. This time, Adam has a net worth of 15 million dollars, and Beatrice an additional 15 million for a combined net worth of 30 million. Adam and Beatrice are both over 70. Adam and Beatrice do as they did in Example 1:

• Adam leaves his 15 million to Beatrice with no tax owed due to the Marital Deduction.
• Beatrice gets Adam's 11.7 million dollar exemption added to hers for an exemption of 23.4 million dollars.
• Beatrice dies with a 30 million dollar estate, 23.4 million of which is exempted from taxation.
• Now Beatrice's estate has to pay tax at a 40 percent rate on the remaining 6.6 million. This could have been avoided by placing that amount in a bypass trust.

Example 4: This time, Adam and Beatrice have a 10 million dollar estate and are in their fifties. Adam dies. Beatrice has more than enough with her 23.4 million dollar exemption to avoid paying taxes, but it is statistically likely that she will live another 20 years or more. In that time, if the estate is invested, it could easily grow to 50 million dollars. Such growth over time is one reason why a bypass trust may be a good idea even with an estate well below the exemption amount.

2) Other Uses for a Bypass Trust Unrelated to Tax Avoidance

There are some uses for a bypass trust that exist at all levels of net worth because they don't concern themselves with tax avoidance. In truth, these are not "bypass trusts" at all in that the intent is not to have estate assets bypass the surviving spouse's estate, but this is a common term for a separate trust than the marital one to which some of the assets are diverted. Some other reasons for a bypass trust are:

• Certainty and control over where the assets eventually end up

Leaving all the money outright to a spouse works fine for some. However, family dynamics may make this an unfavorable outcome. For instance, if either spouse has children from a previous marriage, those children might be excluded from inheriting by the surviving spouse who now owns all the assets. A bypass trust can provide income for life and distributions to the surviving spouse, but ultimately make certain that the money is distributed to the intended beneficiaries named in the trust. Similarly, a bypass trust can prevent someone from influencing the surviving spouse to distribute the money in a way that the now deceased spouse would not have preferred.

• Asset Protection

Assets in a bypass trust that remain in the trust are protected from creditors. If the surviving spouse or the children incur any such liabilities, a bypass trust can be a powerful tool to protect their assets.

• Divorce Protection

Many people have perfectly fine relationships with their son or daughter-in-laws, but it does not take a lawyer to know that in a divorce, otherwise fine relationships can become ugly quickly. In such an instance, you probably do not want the inheritance you leave to your children to be divided and taken by the now ex-spouse of your son or daughter (or any beneficiary for that matter). A bypass trust can protect the assets held in trust from being taken in a divorce.

What are the Drawbacks of a Bypass Trust

As we've seen, a bypass trust can be a powerful estate planning tool, but those advantages have to be weighed against its drawbacks: (1) A loss of step up in basis and (2) the unfavorable tax brackets that trust income falls under.

Basis is the amount that an asset was purchased for. It is used to determine how much tax is owed through a simple calculation. First, one takes the price an asset is purchased for, then, one subtracts that from the price the asset is sold for. The result is taxable gain, or the exact amount that the IRS will require that you pay tax on. A step-up in basis means that the IRS will essentially allow you to reassess the basis at an assets current value. The result is a dramatic reduction in taxable gain. So a home purchased ten years ago for 100,000 dollars and is now worth 500,000 dollars, if sold, will incur a gain of 400,000 dollars on which the seller will pay tax. But with a stepped-up basis, that home would have an adjusted basis to its current value of 500,000 dollars. When sold, the seller would pay no tax because there would be no taxable gain.

A gift upon one's death results in a stepped-up basis for the beneficiary. This is an enormously valuable benefit to the beneficiary and can frequently result in tens of thousands of dollars in tax savings. However, this only applies to assets included in one's estate at the time of death. A bypass trust is not included in one's estate intentionally, and so beneficiaries will lose out on a step up in basis on receipt.

The other tax—and perhaps administrative—drawback of a bypass trust is that a bypass trust requires the trustee to file an annual income tax return. Any taxable income generated by the trust that was not distributed to the beneficiaries is taxed at a high rate. In fact, any income over just $13,500 in a trust is taxed at the highest marginal tax rate of 37 percent! While this is obviously not an issue if the money is distributed—which it typically ought to be—this is something to consider.