Credit Shelter Trust

With the passage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Relief Act) , many planners and clients are wondering what the viability of the Credit Shelter Trust is, if any, since the Relief Act provided for portability with regard to any unused federal estate tax exemption at the first spouse’s death.  Is there really a need for the Credit Shelter Trust since the second spouse to die can add the unused exemption of the first spouse to die to his or her own exemption thereby automatically creating a similar benefit that the Credit Shelter Trust was designed for?

Whether you call it a B Trust, Bypass Trust, Credit Shelter Trust, Family Trust, or Disclaimer Trust, the use is tried and true with regard to the estate planning devices available.  Upon the death of the first spouse, his or her assets which are equal to the estate tax exemption are directed to a trust for the benefit of the survivor.  The trust shields the assets from being included in the estate of the surviving spouse if properly designed, thus potentially reducing the estate tax at the second death.  With portability, the survivor has complete control over all of the assets enjoyed by the couple, contrasted with the limitations imposed by the Credit Shelter Trust, i.e.

1)  A third-party trustee is required or the surviving spouse’s benefit must be limited to the ascertainable standard which equates to the principal being used for health, maintenance, education, and support.

2)  Provided the surviving spouse acts as the trustee then the power over the trust assets are limited so as to be construed as a general power of appointment which would thus cause inclusion in the estate.

3)  Any undistributed income may be heavily taxed.  As an example, in 2011 annual income in excess of $11,350 earned in a non-grantor trust will be taxed at the highest marginal rate, 35%. Compare this to a single filer income which would need to be in excess of $372,950 to be taxed at the 35% level.

As evidenced above, one must ask why create and maintain a Credit Shelter Trust?

One big reason is that portability may not be available when the spouse dies.  The Relief Act was simply a temporary compromise and is due to expire at the end of 2012.  No matter how beneficial portability may look, planning around the permanency of this provision is risky until it actually becomes permanent, if it ever does.

Portability, as currently written in the law, states that an individual may only inherit the credit amount from one decedent spouse.  Thereby, if the survivor remarries and the new spouse then dies, the first decedent spouse’s credit is substituted with the second spouse’s and is lost.

A third consideration is appreciation of assets in the Credit Shelter Trust which will escape possible estate taxation in the surviving spouse’s estate.  Assume two spouses die ten years apart with a current exclusion amount of $5,000,000 in both cases. The first spouse’s $5,000,000 appreciating at 5% in a Credit Shelter Trust will be worth over $8,000,000, allowing for a total of $13,000,000 to pass tax free to the next generation.  If instead the Credit Shelter Trust had not been used and only the portability features were available, then only $10,000,000 would pass tax free.

Another major advantage of the Credit Shelter Trust is leveraging assets within the trust if the spouse decides that he or she does not need those assets to support his or her lifestyle.  As an example, trust assets can be used to purchase a death benefit, utilizing life insurance on the survivor’s life which could then pass free of estate tax to the trust beneficiaries and possibly free of generation skipping taxes.

Most importantly, the use of a Credit Shelter Trust gives assurance to the first spouse to die that the assets will be transferred according to his or her wishes.  As an example, if a surviving spouse is a spendthrift or remarries, any amount that the decedent would have passed via the portability may not end up with the intended heirs or the amount could be diminished drastically.  The Credit Shelter Trust protects assets passing to the next generation as they may be specifically directed via the decedent’s desires written into the Credit Shelter Trust whereas portability leaves the ultimate decision as to who should inherit in the hands of the surviving spouse.  For those that are looking to pass assets from generation to generation and or provide asset protection planning, generation skipping tax allocations are not portable.  To fully take advantage of the generation skipping transfer tax exemptions of both spouses, utilizing the Credit Shelter Trust will be a necessity.

As you can see, there are multiple reasons for the continued use of a Credit Shelter Trust and, thus, this should be discussed at great length with one’s advisors.