The Irrevocable Spousal Trust is an irrevocable trust that you and/or your spouse create during your lifetime for the ultimate benefit of your children.
The trust is structured to be funded using both gifts that qualify for the federal gift tax “annual exclusion” and larger gifts. This technique is novel because normally, gifts between spouses qualify for the federal estate and gift tax marital deduction and must be included in the spouse’s estate at death. Gifts made to an Irrevocable Spousal Trust are not taxed in the survivor’s estate. The current basic exclusion amount of $11,580,000 will expire in 2026, and maybe sooner depending upon the 2020 election results, leaving taxpayers with a “use it or lose it” proposition.
How the Irrevocable Spousal Trust Works
The Internal Revenue Code (the “IRC”) allows each of us to transfer up to $11,580,000 during our lifetimes, through lifetime gifts or transfers that occur at our deaths (this is called the “basic exclusion amount”). Typically, any transfer made to our spouses – lifetime or deathtime – qualifies for the marital deduction and zero tax treatment. This treatment is not something we “elect” — it happens automatically. In fact, we couldn’t change that result if we wanted. So, when assets pass from us to our spouse, they’re tax-free, but (and here’s the catch) the assets are 100% taxable in our spouse’s estate when our spouse dies. Because these gifts are tax deductible when made, they do not use any portion of our lifetime basic exclusion amount.
Because of the deduction-inclusion effect of the 100% marital deduction, lifetime gifts to our spouses generally will not shelter any portion of our basic exclusion amount. The Irrevocable Spousal Trust allows us to transfer money to a trust that benefits our spouse and/or children, but that purposefully does NOT qualify for the marital deduction and is therefore tax- protected.
Those who make gifts made to an Irrevocable Spousal Trust before 2026 (or an earlier post-election change) will “lock in” the benefit of the higher basic exclusion amount, and any future reduction will not impact prior gifts. Hence the urgency to consider substantial gifts in 2020.
Who Benefits From the Irrevocable Spousal Trust?
Following is an example of how you can structure the beneficial interests in the Irrevocable Spousal Trust:
- Your spouse benefits during his or her lifetime.
- At your spouse’s death:
- The assets can (but need not) be subject to your spouse’s power to appoint the trust assets among any combination of your issue and charities, and
- The unappointed assets would remain in trust for your lifetimes of your children (though the trusts could also distribute immediately to each child, if you preferred).
- At the death of each child, they would have power to appoint their share of trust assets among any combination of your issue and charities.
- If at death your child does not appoint all the assets of their trust, then the assets would continue in trust for their issue.
The Economics of the Irrevocable Spousal Trust
What is the Irrevocable Spousal Trust worth, in economic terms?
If you were to transfer $10,000,000 into the trust, the trust earned a steady post-tax return of 3.5%, and you died in 30 years, you would have transferred a little over $18,000,000 to your children free of federal estate tax. If your marginal federal estate tax rate at that time is 40%, then your heirs would save roughly $7,200,000 in taxes. Obviously, if your net investment performance surpasses 3.5%, then the tax savings would be that much greater. If both you and your spouse create identical Irrevocable Spousal Trusts, the tax savings would be doubled.
You can also make gifts of annual exclusion amounts ($15,000) each year to an Irrevocable Spousal Trust, and the same tax savings concept will apply – the amounts transferred, plus the asset growth over time, times the marginal federal tax rate at the time of your death.
Other than market performance risks (and the lost opportunity to make a large taxable gift using some other technique), the only real risk to this technique is that the IRS somehow tries to ignore the trust and includes its assets in your estate. The odds may be better if you do just one trust. However, we think the odds are still very good if you create two trusts (one for each other), so long as the trusts are structured to successfully avoid “reciprocality.”