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
tax exemption. 

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.

Disadvantages

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. 

Doing It Right

If you’ve decided a credit shelter trust is appropriate, there are several key decisions you’ll want to make about how to structure your clients’ estate plans to meet their objectives. Among the questions you should ask are:

Should the funding be automatic? You might want to force the funding of the trust for several reasons: if you are concerned about who controls the assets, if you want to minimize the risk of losing the exemption or if you feel that the law might change again and pose financial disadvantages worse than the income taxes. However, many attorneys now draft wills that allow the executor to make the call after the first spouse dies. That allows him or her the flexibility to do whatever makes the most sense for the family at the time. I have seen this done both ways with my clients, and the family’s objectives drive the conversation.

Who should be named as trustee? Many people name their spouse and give them full discretion to distribute and use the funds, but this can create problems later on. 

Take, for example, a surviving spouse who is named sole trustee of a credit shelter trust for the benefit of her and her children. If that spouse remarries and has additional children, the financial needs of her new family means she’ll spend more of the trust’s assets. And this reduces the chance any of the assets will pass down to the children from her first marriage (especially if they are around the same age as the new spouse).

One possible solution to this problem is to name a co-trustee—a family friend or a third-party corporate trustee—to oversee the use of the funds. In a blended family from multiple marriages, I highly recommend that either a co-trustee or a third-party trustee is used. I have seen situations where the adult children from previous marriages have had issues with the spending of their stepparents because they view the trust as their future inheritance. With this strategy, the adult children have assurance that their stepparent would have to request a distribution and justify the expense to get approval from the co-trustee. While this strategy may generate feelings of mistrust between the spouses when the estate plan is being designed, it can do a lot to reduce the pressure on the surviving stepparent and keep family relations civil after the first spouse is gone. 

When And How Much Should Children Inherit?

I spend a great deal of time working with families to determine “how much is enough” and “when is the right time” for their children to inherit any assets. This is different for each family and even for each child depending on his or her needs.

The issue of “how much” is tricky. Some of my clients want all of their assets to be transferred to the next generation, regardless of the amount. Others have concerns about bequeathing their entire estate or have charitable giving goals. With these clients, we work to determine what type of lifestyle they want to provide and calculate a number or percentage that can be drafted into their estate documents. Then we coordinate with their asset titling and beneficiary designations to achieve the desired results.

Regarding timing, some families choose to keep assets in a trust while the children are younger and distribute a percentage of the assets at specific ages. For example, an adult child could receive one-third of the assets at age 30, another one-third at age 35, and the final amount at age 40. This strategy gives children a “trial run” with the money in case they make bad decisions with the first distribution. 

Other families choose to keep assets in trust for their children’s entire lifetimes. This strategy allows a family to keep the assets in the bloodline for generations and provides some asset protection in the event of a creditor issue or a divorce. 

Working Toward A Favorable Outcome

Good communication within the family is essential. While estate planning decisions may make perfect sense to the parents, they may not make sense to the kids when parents are gone. Once a plan is in place, I encourage my clients to set up a family meeting to let their beneficiaries know how the estate will be divided. Everyone is invited—clients and children from their current and previous marriages. While not a panacea, managing the children’s expectations in advance can reduce a lot of headaches in the future.

At the end of the day, you and your clients must weigh the benefits of control with the downside of force-funding a credit shelter trust, and work with an estate planning attorney to decide what is best for the family.
 

Annika Cushnie is a Partner and Wealth Advisor at Brightworth.