An exemption equivalent trust is an irrevocable trust funded at the first spouse’s death with assets up to the deceased spouse’s remaining federal estate tax exclusion, so that amount and everything it earns afterward passes to the couple’s heirs free of federal estate tax. Estate planners also call it a credit shelter trust or bypass trust. For 2026, it can shelter up to $15 million per person.1Internal Revenue Service. Whats New – Estate and Gift Tax Whether it still makes sense for your family depends on the size of your estate, the state you live in, and how much you value locking in an exclusion that Congress has changed repeatedly over the years.
How the A/B Split Works
Nothing happens while both spouses are alive. The plan activates at the first death, dividing the couple’s assets into two separate trusts.
Trust A, the marital trust, receives whatever exceeds the deceased spouse’s federal exclusion. Those assets qualify for the unlimited marital deduction, meaning any amount can pass between spouses without triggering estate tax.2Office of the Law Revision Counsel. 26 USC 2056 – Bequests, Etc., to Surviving Spouse The surviving spouse controls Trust A outright.
Trust B is where the tax savings live. It holds assets up to the deceased spouse’s remaining exclusion, and once funded, it sits outside the surviving spouse’s taxable estate. The surviving spouse can still benefit from it within limits, but the IRS treats it as a separate entity. When the surviving spouse eventually dies, everything in Trust B, including decades of appreciation, transfers to the named heirs without owing federal estate tax.
The federal estate tax rate on amounts above the exclusion is 40 percent.3Internal Revenue Service. Estate Tax For a couple with $35 million in combined assets, a properly funded bypass trust can shield millions in growth from that rate. Without it, the surviving spouse would own everything outright, and any combined value above their own $15 million exclusion would face the full 40 percent.
The Cost Basis Trade-Off
Assets inside Trust B do not receive a second step-up in cost basis when the surviving spouse dies. The step-up at the first death resets the basis of whatever goes into the trust to its fair market value at that time. Because the trust is irrevocable and sits outside the surviving spouse’s estate, there is no adjustment at the second death.
If the surviving spouse had owned the same assets outright, everything would get a fresh step-up when they died. The heirs could sell immediately with little or no capital gains tax. With the bypass trust, they inherit the basis from the first death, and any appreciation since then is taxable when they sell.
For estates comfortably below the combined $30 million exclusion for married couples, capital gains tax on decades of growth can exceed the estate tax the trust was designed to avoid. A couple with $10 million in combined assets has no federal estate tax exposure at all under 2026 law. Routing half those assets into a bypass trust costs the heirs the second step-up without saving any estate tax. This is the single biggest reason estate plans drafted before 2018 need a fresh review.
For estates genuinely at risk of exceeding the exclusion, the bypass trust still delivers. Growth inside Trust B escapes the 40 percent estate tax, and that benefit compounds. The question is whether the estate is large enough that estate tax savings outweigh the lost basis adjustment.
Funding the Trust
The trust document must include a funding formula that tells the executor how much goes into Trust B. A pecuniary formula directs a fixed dollar amount, typically tied to the federal exclusion in the year of death. A fractional formula assigns a percentage of the estate, which helps avoid problems if assets shift in value between the date of death and the actual transfer. Using the wrong formula can trigger unintended capital gains or even disqualify the marital deduction.
Which Assets to Put In
The smartest approach is usually to place assets with the highest growth potential into Trust B, since all future appreciation escapes estate tax. Diversified investment accounts and closely held business interests are common choices. Real estate works too, but it needs a formal appraisal at the date of death to establish a value the IRS will accept. The asset schedule, sometimes called Schedule A, serves as the trustee’s formal inventory and creates the paper trail the IRS expects.
Keep Retirement Accounts Out
Naming a bypass trust as the beneficiary of an IRA or 401(k) creates a tax problem most families don’t anticipate. Under the SECURE Act, most non-spouse beneficiaries, including trusts, must withdraw the entire balance of an inherited retirement account within ten years of the original owner’s death. If the owner had already begun required minimum distributions, annual withdrawals are required in years one through nine, with the account emptied by year ten.
Those accelerated distributions pile up as ordinary income. If the trust is an accumulation trust that retains the money rather than passing it through, the income gets taxed at the trust’s compressed rates, which reach 37 percent at just $16,000 of income in 2026.4Internal Revenue Service. 2026 Form 1041-ES A conduit trust pushes distributions directly to the beneficiaries, who pay at their own individual rates, but the money then leaves the trust’s protection. Many planners now recommend keeping retirement accounts out of the bypass trust entirely and naming the surviving spouse as direct beneficiary instead.
Life of the Trust After the First Death
Once Trust B is funded, the trustee manages a legally separate taxpayer. The trust gets its own tax identification number, and the trustee files IRS Form 1041 each year to report income, deductions, and distributions.5Internal Revenue Service. About Form 1041, U.S. Income Tax Return for Estates and Trusts
The HEMS Distribution Standard
The surviving spouse can receive money from Trust B, but only within limits. Most bypass trusts restrict distributions to what the spouse needs for health, education, maintenance, and support, known as the HEMS standard. Federal law treats a power limited to those needs as something less than a general power of appointment.6Office of the Law Revision Counsel. 26 USC 2041 – Powers of Appointment If the trustee grants the surviving spouse unrestricted access, the IRS treats the spouse as effectively owning the trust, and the bypass strategy collapses.
Treasury regulations define what counts. Support and maintenance are treated as synonyms and are not limited to bare necessities. Distributions for the spouse’s accustomed standard of living, medical expenses, and education all qualify. A power to use trust property for the spouse’s comfort, welfare, or happiness is too broad and would disqualify the trust.7eCFR. 26 CFR 20.2041-1 – Powers of Appointment; In General The trust language has to track these boundaries carefully.
Compressed Income Tax Brackets
Trusts reach the highest federal income tax bracket at very low income levels. In 2026, a trust hits the 37 percent rate once taxable income exceeds $16,000.4Internal Revenue Service. 2026 Form 1041-ES An individual wouldn’t face that rate until income exceeded roughly $626,000. Income the trust retains gets taxed at these compressed rates, so distributing income to beneficiaries who pay at their own lower rates is almost always more tax-efficient than accumulating it. The trustee has to balance that against the goal of keeping assets inside the trust.
Fiduciary Duties and Final Distribution
The trustee owes a duty to all beneficiaries, not just the surviving spouse. That means weighing the spouse’s current income needs against the remainder beneficiaries’ interest in long-term growth. This role can span decades and requires consistent attention to investment performance, tax filings, and distribution records. Thorough documentation proves the trust operated as a separate entity rather than an extension of the surviving spouse’s personal finances.
When the surviving spouse dies, the trustee arranges a final appraisal and distributes the remaining assets to the named heirs. Because those assets were never part of the surviving spouse’s taxable estate, no federal estate tax applies at the second death.
Portability as the Alternative
Since 2011, a surviving spouse has been able to claim the deceased spouse’s unused federal exclusion, known as the DSUE.8Office of the Law Revision Counsel. 26 U.S. Code 2010 – Unified Credit Against Estate Tax If the first spouse used none of their $15 million exclusion, the survivor can add the full amount to their own, creating a combined $30 million shield without the complexity of a bypass trust.
To claim the DSUE, the executor must file IRS Form 706 within nine months of the date of death, with an automatic six-month extension available through Form 4768.9Internal Revenue Service. Instructions for Form 706 A simplified late-election procedure allows filing up to five years after the date of death if the estate wasn’t otherwise required to file. Failing to file means the surviving spouse permanently loses the deceased spouse’s unused exclusion.
Portability is simpler, but it leaves gaps a bypass trust covers:
- Growth is not shielded. Portability freezes only the dollar amount of the unused exclusion. If the surviving spouse inherits assets outright and they appreciate significantly, all that growth sits in the survivor’s taxable estate. A bypass trust removes the assets entirely.
- No creditor protection. Assets the surviving spouse owns outright are reachable by creditors, lawsuits, and a subsequent spouse in a divorce. Assets inside a properly structured bypass trust are generally protected from the surviving spouse’s creditors.
- No generation-skipping transfer tax coverage. The DSUE does not apply to the GST. Only a bypass trust with a proper GST allocation protects transfers to grandchildren from that separate 40 percent tax.
- Only the last deceased spouse counts. If the surviving spouse remarries and the new spouse dies without a full exclusion, the original DSUE from the first spouse is lost.
Many planners now combine both approaches: fund a bypass trust with high-growth assets and elect portability for whatever exclusion remains unused. That double layer provides the most protection against future appreciation and unpredictable law changes.
When the Trust Still Earns Its Keep
The permanent $15 million exclusion means fewer estates will face federal tax, but a bypass trust still matters in three situations.
State Estate Taxes
Roughly a dozen states and the District of Columbia impose their own estate taxes with exemptions far below the federal level. Some set the threshold as low as $1 million; others land between $2 million and $5.5 million. These states do not follow the federal exclusion, and most do not offer portability between spouses.
This gap is where the bypass trust earns its keep even for estates that owe no federal tax. A couple with $8 million in a state with a $2 million exemption can use a bypass trust to shelter the first spouse’s $2 million state-level exclusion, keeping those assets out of the surviving spouse’s state taxable estate. Without the trust, the entire $8 million sits in the survivor’s estate, well above the state threshold.
Generation-Skipping Transfers
The federal generation-skipping transfer tax applies a flat 40 percent rate to assets that skip a generation, such as property passing directly from a grandparent to a grandchild. The GST exemption matches the estate tax exclusion at $15 million per person for 2026.10Office of the Law Revision Counsel. 26 USC 2631 – GST Exemption
When the executor allocates the deceased spouse’s GST exemption to Trust B, the assets in the trust are permanently exempt from the generation-skipping tax, no matter how much they grow. If the trust eventually distributes $25 million to the grandchildren decades later, the entire amount passes free of GST. Without the allocation, those assets would face a combined 64 percent effective rate: 40 percent estate tax plus 40 percent GST on what remains. The election is irrevocable once made, so getting it right at the first death is critical.
Locking In an Exclusion That May Not Last
A funded bypass trust locks in the exclusion permanently. Portability depends on the law in effect when the surviving spouse eventually dies. Congress has changed the exclusion amount multiple times over the past two decades, and permanent in tax law is a relative term.
What It Costs
An estate plan that includes a bypass trust typically runs between $2,000 and $10,000 or more in legal drafting fees, depending on the complexity of the couple’s assets and whether the plan integrates other vehicles like generation-skipping provisions or life insurance trusts. That is a one-time cost.
The ongoing expenses add up. Professional trust companies charge annual administration fees, generally in the range of 0.3 percent to just over 1 percent of the trust’s principal. On a $5 million bypass trust, that translates to roughly $15,000 to $50,000 per year. Add annual Form 1041 preparation and periodic appraisals of illiquid assets, and the cumulative expense over a multi-decade trust can be substantial. For estates where the tax savings clearly justify the cost, these fees are a reasonable price. For smaller estates that may owe no federal estate tax, the math deserves a hard look before committing.