In 2013, Congress passed changes to the laws on estate taxes, permanently increasing to $5 million the untaxed amounts individuals could exclude from their estates (a number adjusted each year for inflation). What’s more, the law offered “portability” to spouses, allowing somebody who has been widowed to use the deceased spouse’s unused estate
Before the law change, a client’s estate documents would create an entity called a credit shelter trust that was traditionally used to capture the unused credit exemption. With this strategy, when a spouse dies, a credit shelter trust can be funded up to the amount of his or her remaining exemption amount. If we assume that a husband dies first, these assets are then excluded from the estate of his widow when she passes away.
The decedent’s remaining assets would either be distributed outright to the surviving spouse or be used to fund a marital trust. In both cases, these assets would be included in the estate of the second spouse when she dies.
When the law changed, however, this type of planning became unnecessary for everybody except those families whose assets exceeded the combined exclusion amounts for both spouses (which totaled $10.9 million in 2016). But there are still situations where the credit shelter trust is appropriate and even preferable for reasons unrelated to the estate tax.
The trust is still attractive for the following reasons:
It offers control. By using this structure, the first to die can have influence or control over the way the assets are eventually distributed when the surviving spouse passes away. This can be especially important in situations where there has been a previous marriage with children or if the surviving spouse remarries. For example, the first to die can ensure that the children from a first marriage can receive the assets when the surviving spouse passes—and curtail the surviving spouse’s ability to spend down the funds, if the attorney sets up the trust correctly.
The structure also gives individuals the ability to control the way funds are distributed to younger family members. Many families are concerned about giving young adult children too much money, and a proper trust structure can control the amounts and timing of the distributions to the children when the second spouse dies.
It offers asset protection. There can also be some level of asset protection when assets are held in trust for the surviving spouse. Depending on the distribution provisions of the trust and who is named trustee, protection from creditors or from a future divorce—if the surviving spouse were to remarry—can be a benefit.
It helps ensure use of the exemption. Portability is not automatic, and if the proper paperwork is not filed when the first spouse dies, the second spouse may lose the exemption. By forcing the funding of the credit shelter trust, the first spouse to pass on can help ensure that his or her exemption is used.
Despite these appealing qualities, there are disadvantages to the credit shelter trust strategy.
Income taxes. One negative is that the trust’s assets do not receive another step-up in basis at the death of the second spouse because they are not included in the estate of the survivor. If that spouse lives for a long time, there might be substantial appreciation in the assets between the time the first spouse dies and the second one does. While the appreciation would be protected from potential estate taxes, without a step-up in basis, that could mean large income tax bills for the heirs.
Additionally, retirement plan assets held in a credit shelter trust have a much less favorable payout schedule than those held in an individual’s name. Larger amounts have to be paid out as required minimum distributions, which results in higher taxes. Plus, in order for the minimum distributions to be stretched out over the trust beneficiary’s lifetime, the estate planning lawyer must be aware of, and include, special language in the trust document.
The hassle factor. Another negative is that a credit shelter trust is a separate entity and as such requires its own tax ID and tax return. This results in some additional complexity and expense for the beneficiaries.