What is a credit shelter trust and why would you want one?
Let’s posit a scenario. A husband and wife each have an estate valued at $5 million. Husband dies, bequeathing his $5 million estate to his wife. She now has an estate that is valued at $10 million. Since the federal exemption for an estate tax is around $5.5 million, wife will not have to pay estate taxes when she inherits husband’s estate. However, when wife attempts to pass her estate on, it will exceed the exemption threshold and thus be subject to estate taxes.
While this situation is unfortunate, there are methods of reducing the overall value of an estate and one of those methods is a credit shelter trust.
How Does a Credit Shelter Trust Work?
A credit shelter trust is an irrevocable living trust that transfers valuable assets out of your estate. An irrevocable living trust can hold assets separately from your estate. Since the trust is considered irrevocable (meaning it can’t be dissolved or otherwise allow a beneficiary or a trust-maker to transfer assets out of the trust once they’re in there) the assets held within the trust are considered property of the trust and not your property per se.
Why Invest in a Credit Shelter Trust?
High-assets estates are served best by credit shelter trusts. Since assets held in these trusts are not considered “your” property any longer, they do not count for the purposes of levying an estate tax. If a surviving spouse inherits property from their spouse, there is an unlimited estate tax exemption that works in their favor.
However, when the second spouse dies, their estate will be considered part of a single lump sum for tax purposes. Taxes on estates that surpass the $5.43M exemption can be heavy. For this reason, high-asset families invest in credit shelter trusts to protect their estate from taxes.
How Is It Funded?
There are two basic ways of funding a credit shelter trust. The first is by mathematical formula. Essentially, you determine how much of your assets go into the trust to avoid paying the overage on the $5.43M exemption. However, once the assets change hands, the funding of the trust must be carried out.
As an alternative, credit shelter trusts can be funded by disclaimer. This allows the surviving spouse to decide whether or not they will fund the trust. In other words, it gives them an out if they don’t want to fund the trust.
What Are the Benefits of Having One?
Aside from reducing the overall size of your estate for tax purposes, credit shelter trusts can be drafted to grant the surviving spouse access to the income generated by the trust as well as the principal. Even though the property is not technically considered a part of your estate, you can still reap the benefits of it in the form of income. You will have to pay taxes on the income, but that is a separate issue entirely. You would not be passing the tax burden onto your heirs simply because you’re deriving an income from the trust.
What About Portability?
Portability allows a surviving spouse to claim the deceased spouse’s automatic exemption for later use. Is portability preferable to using a credit shelter trust? The answer to that question depends on your unique circumstances:
If the surviving spouse remarries, they will lose their ported exemption. This can put them in a bit of a bind.
Similarly, portability only applies to federal estate taxes, not state-level estate taxes. You may end up paying some state taxes if you choose portability over a credit shelter trust.
Portability likewise does not apply to generation-skipping tax exemptions. It would be necessary to have a credit shelter trust to bypass federal estate taxes.
Lastly, a credit shelter trust, which is not considered the property of the beneficiary, is not subject to a creditor’s attempts to collect debts using the trust’s assets. And, because it’s a trust, it controls how assets are distributed.