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  • Trusts 101

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    Credit Shelter Trust: Use It or Lose It

    Federal tax laws are complicated. They state, for example, that you and your spouse both get a $5 million-plus federal estate tax exemption. More accurately, your estate gets those exemptions, also known as the applicable exclusion amount, after you’re both gone. So you might assume that the both of you automatically trigger at least a combined $10 million exemption. Uh-uh. You either use it or lose it.

    Estate taxes are nothing if not complicated. Spouses have an unlimited exemption, called a marital deduction. They receive any amount of assets from a deceased spouse without having to pay a dime of federal estate taxes. The problem potentially arises when the surviving spouse dies. Let’s say both spouses have $5 million of assets in their name. The first one dies, having spent only $2 million. The surviving spouse takes ownership of the unused $3 million. Now, the total estate is worth $8 million.

    When the surviving spouse dies with $8 million in assets, the amount exceeds the federal estate tax exemption by almost $3 million. Heirs are responsible for paying federal estate taxes, which begin at 40%. That’s roughly $1.2 million due in federal estate taxes and that doesn’t count potential state estate and inheritance taxes-all because the first spouse didn’t use the full exemption.

    Another complicating factor: your estate may still owe state estate and inheritance taxes. These exemptions are often much lower than the federal threshold.

    A Problem for Asset-Rich, Cash-Poor Estates
    You may not have a problem with your heirs paying estate taxes. But this becomes a problem when a family business comprises most of an estate’s value and is meant to pass to the next generation. In order to pay the estate tax bill, family business successors could have to sell all or part of the business.

    To offset this tax bite, some business owners buy life insurance, with the death benefit earmarked to pay off taxes. This benefit, however, also adds to the estate tax bill. To avoid estate taxes on the life insurance, some people set up a life insurance trust. Others turn to a credit shelter trust.

    Give Me Shelter
    Also called a bypass trust or AB trust, this trust ensures that both spouses get to use their full estate tax exemptions. This is how it works. The grantor, the person creating the trust, puts the trust provisions in a will. One term of the trust definitely will include putting the entire applicable exclusion amount, or exemption, in writing. The trust is revocable, so you can change its terms at any time during your lifetime. It becomes an irrevocable trust when you die, and assets—usually what’s left of the estate tax exemption—go to the trust.

    Now, the surviving spouse may receive income from the trust’s assets. When the surviving spouse dies, beneficiaries receive the trust’s asset estate tax-free. By using a trust, heirs don’t have to worry about unused estate tax exemptions.

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    A credit shelter trust is the perfect instrument to ensure a legally married couple passes their full estate tax exemptions on to heirs. Know, however, that this trust is revocable and will not offer any additional tax advantages beyond ensuring two full exemptions. For greater tax efficiency, an irrevocable trust may be more appropriate. An estate planning attorney can tell you more about these and other trusts.