For years, the credit shelter trust has been a standard weapon in married couples’ estate planning arsenals. Today, however, a $5.34 million estate tax exemption amount combined with portability of exemptions between spouses means that traditional estate planning vehicles are less critical than they once were. Nevertheless, credit shelter trusts continue to offer significant benefits, particularly for high-net-worth taxpayers.
Affluent families looking for ways to reduce their gift and estate tax bills should consider a Supercharged Credit Shelter TrustSM (SCST)*. An SCST enhances the benefits of a conventional credit shelter trust.
Making the most of the exemption
To understand how an SCST works, some background on the credit shelter trust is necessary. A credit shelter trust is designed to take advantage of each spouse’s exemption and ensure that neither is wasted. Suppose, for example, that Jane’s estate is worth $15 million. If she leaves all of her wealth outright to her husband, Allan, the unlimited marital deduction will shield it from estate taxes. Before portability, if Allan were to die and leave $15 million to the couple’s children, his estate would owe $3,864,000 in estate taxes (assuming a $5.34 million exemption and a 40% tax rate).
Had Jane set up a testamentary credit shelter trust, the tax bill would have been substantially smaller. The trust, funded with an amount equal to Jane’s estate tax exemption ($5.34 million) would provide Allan with an income interest for life, after which the funds would then go to the couple’s children. The trust would take full advantage of Jane’s exemption and, by limiting Allan’s rights to the trust principal, the funds would bypass his estate. The remaining $9,660,000 in Jane’s estate would pass to Allan either outright or in a marital trust. When Allan dies, assuming his estate is worth $9,660,000 (and the exemption amounts and tax rates haven’t changed), the estate tax would be $1,728,000, for a $2,136,000 savings.
Portability allows a couple to take advantage of both spouses’ exemptions without the need for a credit shelter trust or other sophisticated estate planning tools. Provided certain requirements are met, portability allows a surviving spouse to add a deceased spouse’s unused exemption amount to his or her own. So, in the previous example, Jane could have left $15 million to Allan outright, and Allan could have added Jane’s exemption to his own, shielding $10.68 million from taxes in his estate. Assuming Allan’s estate is still worth $15 million when he dies, the estate tax liability would be $1,728,000 ($15 million – $10.68 million × 40%), the same tax outcome as a credit shelter trust.
There are several disadvantages to relying on portability, though. First, unlike a credit shelter trust, portability doesn’t shield future income and appreciation from estate taxes. Suppose, for example, that Jane’s estate plan establishes a credit shelter trust funded with $5.34 million in assets. If, when Allan dies, the trust’s value has grown to $8.34 million, the $3 million in appreciation will bypass Allan’s estate and escape estate taxes. Had Jane relied on portability, that $3 million in growth would end up in Allan’s estate, potentially triggering an additional $1.2 million in estate taxes.
Second, portability doesn’t apply to the generation-skipping transfer (GST) tax exemption. So, for couples who wish to preserve both spouses’ GST tax exemptions to reduce taxes on gifts to their grandchildren, a credit shelter trust is the best option.
Finally, credit shelter trusts offer some protection from creditors’ claims against the trust assets. Outright gifts offer no such protection.
Enhancing the benefits
One drawback of a conventional credit shelter trust is that taxes on the trust’s income hamper its ability to grow and compound for the benefit of the trust beneficiaries. Under the complex distributable net income rules, trust income is taxed to the trust or to the beneficiaries (or both), depending on the amount of distributions the trust makes each year. Either way, these taxes erode the trust assets, leaving less for the beneficiaries.
An SCST “supercharges” the credit shelter trust by ensuring that it’s treated as a grantor trust with respect to the surviving spouse. As grantor, the surviving spouse pays the taxes on the trust’s income, allowing the trust assets to grow tax-free for the beneficiaries.
Under the grantor trust rules, the grantor’s tax payments don’t constitute taxable gifts to the beneficiaries. Essentially, by paying taxes that would otherwise come out of the trust’s income, the grantor makes an additional, tax-free gift to the beneficiaries.
How do you ensure grantor trust treatment? After all, credit shelter trusts ordinarily are established by bequest according to the deceased spouse’s will or revocable trust, so the deceased spouse is the grantor.
One way is to give the surviving spouse the right to withdraw trust principal, but this would cause the trust assets to be included in his or her estate. The key to an SCST is for the spouse who ultimately will be the surviving spouse to set up a lifetime qualified terminable interest property (QTIP) trust to fund a credit shelter trust of the first spouse to die. The QTIP trust assets will be included in the deceased spouse’s estate, and the surviving spouse will be treated as the grantor (for income tax purposes) of the credit shelter trust created from the QTIP trust. (Be aware that, for this strategy to work, the beneficiary spouse must be a U.S. citizen. Otherwise, the QTIP trust won’t qualify for the marital deduction, exposing the trust to gift tax.)
Watch out for reciprocal trusts
Typically, a couple who wish to take advantage of a Supercharged Credit Shelter TrustSM (SCST) each establishes a lifetime qualified terminable interest property (QTIP) trust for the benefit of the other, designed to fund a credit shelter trust for the benefit of the surviving spouse. A couple who create identical trusts at the same time risk running afoul of the reciprocal trust doctrine, which can unravel an SCST’s tax benefits. The doctrine prohibits a couple from avoiding taxes by using trusts that 1) are interrelated, and 2) place each grantor in the same economic position as if they’d each created trusts naming themselves as beneficiaries.
For SCSTs, the biggest risk is that the IRS will invalidate the QTIP trusts, causing the entire amount contributed to the trusts to be taxable gifts. There are several ways to avoid the reciprocal trust doctrine, including giving each QTIP trust beneficiary a special power of appointment, varying the terms of the trusts so they’re not identical or establishing the trusts at different times.
Careful drafting required
To make an SCST work, you need to consider a number of complex gift and estate tax rules, including the reciprocal trust doctrine. (See “Watch out for reciprocal trusts” on page 3.) Careful drafting is required to avoid triggering unnecessary gift, estate or income taxes.