Have credit shelter trusts become obsolete?

Estate planning for married couples

If you’re married, a couple of estate planning objectives likely loom large in your mind. First, you probably want to ensure your spouse will have sufficient assets to maintain his or her lifestyle after your death. Second, you no doubt wish to protect your wealth from estate taxes so that as much as possible ultimately goes to your children (or other heirs).

One way to accomplish both goals is to set up a credit shelter trust (also sometimes referred to as a “bypass” trust). Essentially, it preserves your estate tax exemption for eventual tax-free disposition of assets to your children while first benefiting your spouse for the remainder of his or her life.

But have the increase in the estate tax exemption and the availability of exemption “portability” under last year’s tax relief legislation made these trusts obsolete? For many taxpayers, the answer is a resounding “no!”

It’s about the exemption

Whether you and your spouse should consider a credit shelter trust rests largely on how the size of your estates together compares with the estate tax exemption. Generally, if your and your spouse’s estates will total less than the estate tax exemption, a credit shelter trust won’t be necessary for estate-tax-saving purposes.

With the exemption now at $5 million, if your current net worth is lower, you may feel safe from estate tax. But keep in mind that the exemption is scheduled to drop back down to $1 million in 2013. Also, what matters isn’t what your estate is worth now but what it will be worth at your death. So there may be a good chance that, by the time of your death, your estate will exceed the estate tax exemption — even if it doesn’t now.

How the trust works

Let’s say you and your spouse both have $5 million estates and you leave your entire estate to your spouse. No federal estate tax will be due on your death because of the marital deduction, which allows you to transfer an unlimited amount to your spouse free of estate tax (unless your spouse isn’t a U.S. citizen, in which case special rules apply).

But, if your spouse later dies with an estate of $10 million and the exemption is still $5 million, his or her estate will owe $1.75 million in estate taxes (assuming the current 35% estate tax rate and that your spouse doesn’t remarry and bequeath assets to the new spouse tax-free under the marital deduction). And if he or she dies after 2012 and, as scheduled, the exemption amount drops to $1 million and the top estate tax rate returns to 55%, the tax will be $4.795 million.

In other words, leaving all of your estate to your spouse can waste your exemption, resulting in unnecessary estate tax and a smaller (perhaps significantly smaller) inheritance for your children. The simple solution is to bequeath assets up to the estate tax exemption amount directly to your children. But “disinheriting” your spouse in this way may not be desirable. This is where a credit shelter trust can serve a purpose.

Your estate plan can direct assets up to the exemption amount to be transferred on your death to the trust. The trust provides an income stream for your spouse and certain rights to the principal for life, and what remains at your spouse’s death goes to your children or other beneficiaries — estate-tax-free under your exemption.

Essentially, the credit shelter trust allows you to make full use of your estate tax exemption without jeopardizing your spouse’s financial well-being. The assets basically “bypass” his or her estate — thus the alternate name for the trust. One important caveat: You can’t use assets held in joint tenancy for the trust.

Problems with portability

On the surface, estate tax exemption portability may seem to eliminate the need for a credit shelter trust. It allows any remaining estate tax exemption available at one spouse’s death to be used by the surviving spouse. While it may sound simpler than setting up a credit shelter trust, portability generally isn’t a better alternative.

First, portability is scheduled to expire after 2012. So you can’t depend on it being available. Even if you or your spouse dies before it expires, the survivor would have to use up the deceased spouse’s remaining exemption by the end of 2012.

Second, portability can’t be used to leverage the estate tax exemption in the same way that a credit shelter trust can if assets appreciate. Let’s consider our previous example and say that the credit shelter trust assets appreciate to a value of $7 million by your spouse’s death. The entire $7 million trust balance will pass estate-tax-free to your children. But without the trust, only $5 million could be protected from estate tax under exemption portability, if still available.

Still valuable

Although the increase in the estate tax exemption to $5 million and the availability of exemption portability may make credit shelter trusts seem less important, these arrangements can still serve a useful purpose for many married couples. After all, the estate tax “certainty” under current rules is only temporary. Therefore, the benefits of these trusts should be valuable for years to come.

Already have a credit shelter trust?

If so, you need to review your estate planning documents in light of the current $5 million estate tax exemption and the scheduled 2013 return of the $1 million exemption. You’ll want to make sure the document language is written in a way that you can make the most of your estate tax exemption, regardless of the amount.

If your estate plan language calls for a fixed dollar amount to go to the credit shelter trust, that language may need to be revised. Otherwise, if you die in 2011 or 2012, you might not be able to protect your full $5 million exemption.

For example, the language might say that $3.5 million (the 2009 estate tax exemption) will go into your credit shelter trust and the rest of your estate will go directly to your spouse. If your total estate is $5 million, then $1.5 million will go to your spouse outright.

If your spouse dies with a $1.5 million estate after 2012 — when the lifetime exemption is only $1 million — $500,000 will be subject to estate tax, which would be $210,000. Had the full $5 million gone instead to the credit shelter trust, no estate tax would be due on your spouse’s death.

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