Let’s say that dad died in 1995. At the time, mom and dad’s joint estate was worth about $1.2 million. If dad left his half to mom, she would have an estate of $1.2 million. When mom died, she would only receive an estate tax exclusion of $600,000. This would expose dad’s $600,000 to the 55% estate tax and the tax bill would have been $330,000.

So, instead, mom and dad’s attorney drafted a trust that would fund a bypass trust with dad’s assets equal to the estate tax exclusion amount of $600,000 that was in place at the time. It preserves dad’s estate tax exclusion. Some attorneys use the term “credit shelter” trust instead of bypass trust.

Now, mom has survived dad by 20 years and still counting. Since then, mom’s assets have grown to $2.4 million and dad’s bypass trust has done the same. The total is $4.8 million. Today, mom’s estate tax exclusion is nearly $5.5 million. My, how times have changed. While unforeseeable in 1995, had dad left to mom his half of their joint estate – even with the subsequent growth – mom’s estate would not be subject to estate tax. One will be quick to say that in either case, neither mom nor dad would be subject to estate tax. So, what’s the point? The answer is income tax.

As we recall, when a person dies and assets pass to beneficiaries, the assets receive a new cost basis for capital gain tax purposes – it’s called a “step up.” The new cost basis is the fair market value on the individual’s date of death. For mom, let’s say 2015. Any unrealized appreciation on assets in mom’s estate will evaporate for income tax purposes. For dad, it was 1995. Any unrealized appreciation on assets in dad’s bypass trust will NOT receive a basis adjustment and unrealized tax liabilities remain.

Wouldn’t it be great if we could somehow pull the assets from dad’s bypass trust into mom’s estate? Remember, doing so will not create an estate tax liability. Mom’s combined assets remain below the current $5.5 million exclusion. But, dad’s assets in mom’s estate would receive a full step up in cost basis and side capital gain tax on the unrealized appreciation as of mom’s date of death.

The Delaware Tax Trap – which can occur anywhere – is triggered when a trust is moved to a jurisdiction different from that of its creation, the new jurisdiction has differing estate rules (such as allowable term of a trust), and the trust’s terms have been so changed. The result is the assets of the trust are pulled into the estate of a given beneficiary . . . exposing the assets to estate tax again. That’s the trap.

In mom’s case, though, pulling dad’s assets into her estate does not expose her to the estate tax. But, being in mom’s estate, dad’s assets now receive a step-up in basis. We have intentionally triggered the Delaware Tax Trap to substantially reduce the family’s overall tax liability.

This is just one example of how a properly executed decanting can help a family reduce its tax burden.

Source: Forbs