Are Credit Shelter Trusts Still Needed?

Posted May 6th, 2011

Why is this Topic Important to Wealth Managers? This blogticle presents an overview of the credit shelter trust. Given the $5 million estate and gift tax exemption, along with the portability of the spousal credit, and wealth managers and clients alike are asking how this will affect estate plans. We thus review the credit shelter trust so as to provide information for decision making regarding client estate plans given the new estate and gift tax legislation.

The unlimited marital deduction is “superficially” attractive. The wealthier spouse doesn’t have to worry about estate tax erosion of assets transferred to a surviving, less wealthy spouse. But what about the second death? The unified credit and portability may be sufficient in some cases to shelter the estate, but not always. Therefore, some affluent families benefit from the split-estate (A-B Trust) concept in marital deduction planning. The benefits arising from the use of such instrument are nevertheless being questioned by wealth mangers given the new estate and gift tax exemption amounts.

While the marital deduction provides a tremendous tax benefit at the first death, it largely postpones the estate tax on the qualified property until the second spouse dies. Since most clients are anxious to conserve as much of the estate as possible for succeeding generations, proper estate planning considers the effects of the combined estate tax on both spouses’ estates and takes steps to keep death taxes at a minimum in the survivor’s estate as well as at the first death.

For many years the testamentary credit shelter trust has been a standard element in estate planning for married persons. These trusts, created upon death and funded to the extent of the decedent’s applicable exemption amount, still represent a vast potential market for the sale of life insurance. Life insurance on the life of the surviving spouse can be a highly suitable asset for credit shelter trusts. This discussion focuses on the advantages of life insurance as an asset of a credit shelter trust notwithstanding the increased gift and estate tax exemption amount and spousal portability.

Significant advantages can be achieved by widows and widowers and their heirs who are beneficiaries of credit shelter trusts (established upon the deaths of their respective spouses), through the purchase by the credit shelter trust of insurance on the life of the surviving spouse.

One of the appealing aspects of investing credit shelter trust assets in life insurance is that when the trust is ultimately distributed to children (or other heirs) after the death of the surviving spouse, the property will have achieved, in effect, two successive step-ups in basis subsequent to the death of the first spouse.

In summary, it works as follows: Consider a spouse with appreciated assets who dies. The appreciated assets are transferred by the decedent’s will to a credit shelter trust, taking a stepped-up basis equal to the market value at which they were included in the gross estate. Assume that before the assets appreciate further in value some portion is sold by the trustee at no taxable gain. The proceeds of the sale are used to purchase an insurance policy on the life of the surviving spouse. When the surviving spouse dies, the death benefit will be received by the trust income tax free under I.R.C. §101. Thus, in effect, the property that was received by the trust with a stepped up basis upon the death of the first spouse will have grown to an amount equal to the insurance death benefit by the time the second spouse dies. This second increase in value (occurring between the death of the first spouse and the death of the second spouse) is not subject to income tax, because of Code §101, and thus, there has effectively been a second step-up in basis for the increased asset amount eventually received by the couple’s heirs.

Next week’s blogticles will present discussion related to estate planning generally.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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4 Responses to “Are Credit Shelter Trusts Still Needed?”

  1. Vince Gallo says:

    Depending upon the stability of estate tax law to provide comfort in estate planning is similar to being hungry and standing in the wind waiting for fried chicken to fly into your grasp!

    Look at the history of changes in the law – since 1986, no less its history from 1787(yes 1787!). The current $5 million window expires on 12/31/2012, not a very long time horizon for planning. The law reverts to$1 million and the original 55% to marginal rate for estates above a given dollar value. We can opine that the law will change but…did ANYBODY really think that there would be a zero tax environment in 2010?

  2. David F. Sterling, Esq. says:

    It’s unfortunate, but advisors seem moribound to a myopic view of trusts. There is a reason that clients do not have a broader understanding and appreciation for trusts other than tax management and probate avoidance. We perpetuate it.

  3. Benjamin Terner says:

    Thank you kindly for your comment. I think your perspective is interesting and there may be something to what you’re saying. What’s the solution?

  4. Benjamin Terner says:

    Thanks Vince. What are your thoughts about what will occur in 2012 and beyond, and how are you advising clients? BT

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