A credit shelter trust (CST) is a trust created after the death of the first spouse in a married couple. Assets placed in the trust are generally held apart from the estate of the surviving spouse, so they may pass tax-free to the remaining beneficiaries at the death of the surviving spouse. The assets held in the CST can benefit the surviving spouse during their lifetime. Credit shelter trusts are also commonly known as bypass, family, or exemption trusts. Because transfers to surviving spouses are generally free from federal estate tax, CSTs can be used in conjunction with the unlimited marital deduction. At death, if the executor or trustee is directed to fully fund the CST, assets totaling the deceased spouse’s available lifetime federal gift and estate tax applicable exclusion amount would be transferred to a CST for the benefit of the surviving spouse for their lifetime. When the surviving spouse dies, the trust assets will pass tax-free to the CST beneficiaries. The CST shelters the assets and any appreciation in the value of the assets from inclusion in the surviving spouse’s estate.
To derive the maximum federal estate tax benefit, each spouse should own enough assets in their own name so the value of each spouse’s assets meets (to the fullest extent possible) or exceeds the applicable exclusion amount. At the election of the surviving spouse, the Internal Revenue Code provides for the transfer of the first-to-die spouse’s unused applicable exclusion amount to the surviving spouse, who can then use it for their gift or estate tax purposes. Although relying on portability may be easier than creating and administering a CST, a CST has several advantages over electing portability: All appreciation in the value of the assets in the CST bypasses the surviving spouse’s estate and will not be subject to federal and/or state estate taxes at the surviving spouse’s death. Portability is generally not permitted for state estate tax exclusions (for states that levy state estate tax) and the federal generation-skipping transfer tax exclusion. Therefore, without the use of a CST, any unused state estate tax exclusion and generation-skipping transfer tax exclusion of the first spouse to die will be lost. Assets contained in a trust are generally protected from the beneficiary’s creditors. The first spouse to die can control where the assets remaining in the trust are distributed after the surviving spouse’s death rather than relying on the surviving spouse to carry out the wishes of the first spouse to die.
Estate Planning Considerations
When consulting with your attorney or tax advisor, consider the possible downsides to a credit shelter trust:
• Income tax returns must be filed for the trust in order to obtain the benefits of a CST. If the assets that are used to fund the trust are complicated this filing can be cumbersome and expensive.
• The tax basis of the assets in a CST is stepped up only once—at the death of the first spouse unlike with portability, where the tax basis would be stepped up a second time upon the death of the second spouse.
• The surviving spouse must be willing to accept only certain rights and limited control over the assets in the trust. Generally speaking, they can access all of the trust’s income, and as the trustee, can draw on the principal to pay for health, education, maintenance, and living expenses. If the trustee is someone other than the surviving spouse, typically that spouse may receive trust assets for other reasons at the trustee’s discretion.
• The Tax Cuts and Jobs Act of 2017 may impact the amount of assets that flow to a CST. If a CST is automatically funded, the amount of assets that might be more readily available to the surviving spouse may be reduced or eliminated due to the increase in the applicable exclusion amount. Consider speaking with your attorney to understand how this impacts your situation.
Portability is now a permanent part of the federal estate tax system, which means each spouse’s estate tax exclusion that is unused at death is “portable” and can be carried over to the surviving spouse. Portability was enacted as a temporary provision in 2011, but Congress has made this important provision permanent. Portability can simplify estate planning significantly. Before portability, married couples had to divide and re-title ownership of their assets between them so that each had about the same level of net worth. Their will (or revocable trust document) also had to establish a trust on the death of the first spouse in the amount of the estate tax exclusion. This path fully used the couples’ estate tax exclusions, and effectively “sheltered” the assets by funding what is termed a “credit shelter trust.” This trust is sometimes called the “bypass trust” because it bypasses the taxable estate of the surviving spouse. It’s also called the “B Trust” in A/B trust planning or simply the “family trust” because in addition to estate tax savings, it provided for the family of the decedent after death, including the surviving spouse, children, and potentially even the grandchildren. Compared to a credit shelter trust, portability is simple. A husband and wife can put together a basic will that leaves all of their assets to each other, without the complication of a trust. A long-married couple often prefers the ease of having their assets in joint tenancy. Portability works well with jointly held assets as well.
How Credit Shelter Trust is Funded
There are generally two ways to fund the credit shelter trust.
• By mathematical formula: The document might allocate as much of the deceased spouse’s property to the credit shelter trust as possible without triggering an immediate estate tax. This is a mandatory funding method because the plan must be carried out.
• By disclaimer: An alternative method is the disclaimer funding method, which gives the surviving spouse the discretion whether to fund the credit shelter trust. This might be appropriate if funding the trust would not be likely to save any taxes. This method is optional.
At the time when couples are celebrating the beginning of their lives together, the last thing most are thinking about is death and estate taxes. However, as married couples accumulate wealth over the years, many make the common mistake of not establishing a proper estate plan to protect the wealth that they have built. Most couples understand that they can transfer assets at death to the surviving spouse, estate tax free. However, what they may not understand is that this can lead to a tax trap when the second spouse dies and the assets are passed on to beneficiaries. Without proper planning, those assets may be exposed to estate taxes, which could result in a 41 to 49 percent reduction in their value. Under current law, a person can pass any size estate to his or her spouse without federal estate tax because of the unlimited marital deduction granted by IRC Section 2056. Also, the IRS grants each spouse a unified credit, which can be used to reduce the amount of estate taxes due. For 2004, the unified credit of $555,800 will protect approximately $1,500,000 of taxable estate assets. The credit amount will gradually increase to $1,455,800 in 2009, thus excluding approximately $3.5 million of taxable estate assets. If, upon the death of the first spouse, all assets are transferred to the surviving spouse using the unlimited marital deduction, when the surviving spouse later dies and passes the combined estate to his or her beneficiaries, there is only one unified credit to reduce the estate tax. To preserve the unified credit of the first spouse to die, couples can use a credit shelter trust (also called a ‘by-pass’ or ‘exemption’ trust). When the first spouse dies, an amount equal to the approximate amount protected by the unified credit (currently up to $1,500,000) is placed into the shelter trust. This trust is not taxed at that time or at the later death of the surviving spouse, even though it may appreciate in value. By utilizing a credit shelter trust that takes advantage of federal credits, sometimes twice as much can be transferred to beneficiaries free of federal estate taxes.
A Credit Shelter Trust Hypothetical Example
Assume Jim and Mary’s combined taxable estate is worth roughly $2 million and is divided equally between them. Jim dies in 2004. Without a credit shelter trust, all of his assets would pass to Mary estate tax free because of the marital deduction, making Mary’s total estate worth $2 million. If Mary were to die in 2005, the first $1,500,000 of her estate would be exempt from estate taxes. However, the remaining $500,000 would be subject to $225,000 in taxes, leaving only $1,775,000 for her beneficiaries. This taxable event would happen because only one unified credit was used for Jim and Mary’s joint estate. With a credit shelter trust. Jim would stipulate that at his death $1,500,000 would go directly into a credit shelter trust, to help provide lifetime income for Mary. Because Jim’s assets had been put into the trust, Mary’s estate would be worth $1,500,000. If Mary were to die in 2004, her $1,500,000 would not be subject to federal estate taxes because it would be equal to the amount protected below her federal tax credit. Hypothetically, Jim and Mary could save their beneficiaries $225,000 in federal estate taxes.
You’ve worked hard to accumulate your assets. There may be something you can do to make sure that they are passed on to your beneficiaries. If you are married and have a net worth of $1,000,000 or more, a credit shelter trust may help you transfer more assets free of estate taxes. Remember that your situation is unique and fees, charges and tax consequences should be evaluated carefully. In order to have an appropriate estate plan developed for you, consult your financial professional. A financial professional will be able to talk to you about how personal trusts can help you develop effective wealth preservation strategies for you and your family. Married couples can maximize the use of both of their federal exemptions from estate taxes by using AB Trusts as part of their estate plan. The AB Trust system can be set up under the couples’ Last Will and Testaments or Revocable Living Trusts. The “A Trust” is also commonly referred to as the “Marital Trust,” “QTIP Trust,” or “Marital Deduction Trust.” The “B Trust” is also commonly referred to as the “Bypass Trust,” “Credit Shelter Trust,” or “Family Trust.”
Estate Planning AB Trusts and Portability of the Estate Tax Exemption
Note that beginning in 2011, the federal estate tax exemption was made transferable between married couples. This is referred to as “portability of the estate tax exemption” and means that if one spouse dies in 2011 or later and his or her entire federal estate tax exemption is not needed to avoid estate taxes, then the unused portion of the deceased spouse’s estate tax exemption can be added to the surviving spouse’s estate tax exemption. This, in essence, means that in 2021 a married couple will be able to pass on up to $23.4 million on to their heirs free from federal estate taxes without the need to use AB Trust planning. If the spouses have different sets of final beneficiaries, such as in the case of a second or later marriage where each spouse has their own children that they want to inherit their separate assets after both spouses are deceased, then the couple will want to make use of AB Trust planning in order to ensure that their separate beneficiaries will be their ultimate beneficiaries. Finally, the federal generation-skipping transfer tax exemption is not portable, so couples who want to double the use of their GST exemptions will need to use AB Trust or ABC Trust planning to do so.
How Credit Shelter AB Trust Planning Works
Here is how the AB Trust system works to maximize the use of both spouses’ estate tax exemptions:
• The couple includes the appropriate AB Trust language in their Last Will and Testaments or Revocable Living Trusts. Note that this should not be attempted without the assistance of a qualified estate planning attorney.
• The couple divides their assets so that each spouse has about the same value of assets in his or her individual name or in the name of his or her Revocable Living Trust. This is an important step and must be done in order for the AB Trust system to work. Many times, couples leave their assets in joint accounts and this completely voids the use of the AB Trust system since the joint assets will pass outright to the surviving spouse instead of through the deceased spouse’s Last Will or Revocable Living Trust.
• If the first spouse dies, a sum up to the personal exemption amount will be funded into the B Trust. This effectively uses the federal exemption from estate taxes of the first spouse to die. The B Trust can be relatively flexible and used for the benefit of the surviving spouse and descendants or other beneficiaries.
• If the deceased spouse’s assets exceed the exemption amount, then the excess is funded into the A Trust. This will defer the payment of estate taxes on the assets above the deceased spouse’s exemption until after the surviving spouse’s death. Due to this estate tax deferment, the A Trust is less flexible and can only be used for the benefit of the surviving spouse. In addition, federal law requires that the surviving spouse must receive all of the income from the A Trust in order for it to qualify for the unlimited marital deduction.
• When the surviving spouse later dies, the surviving spouse will still have his or her own estate tax exemption. If the exemption is $5,340,000 when the surviving spouse dies, then the first $5,340,000 of the surviving spouse’s separate assets will pass estate tax-free to the final beneficiaries. Anything over $5,340,000 will be taxed.
• The assets remaining in the B Trust pass estate tax-free to the final beneficiaries. This is because the B Trust used up the federal estate tax exemption of the first spouse to die, so anything left in the B Trust will pass estate tax-free. This can provide a significant windfall to the final beneficiaries if the surviving spouse does not need to use the assets from the B Trust and they continue to grow in value during the surviving spouse’s remaining lifetime.
• The assets remaining in the A Trust will be taxed as part of the surviving spouse’s estate. As mentioned above, the estate tax on the A Trust is effectively deferred until after the surviving spouse dies.
• The balance of the A Trust that remains after the estate tax bill is paid passes to the final beneficiaries. Note that the beneficiaries of the A Trust and B Trust can be different.
Effective use of the AB Trust system allows married couples to pass on up to $23.4 million to their final beneficiaries, free from any federal estate taxes based on 2021 limits while ensuring that their separate estates will ultimately pass to the beneficiaries of their choice and in the manner of their choice.
Credit Shelter Trust Lawyer
When you need a credit shelter trust, please call Ascent Law LLC for your free consultation (801) 676-5506. We want to help you.
8833 S. Redwood Road, Suite C
West Jordan, Utah
84088 United States
Telephone: (801) 676-5506