Credit shelter trusts are popular tools used to help married couples double the amount that they can leave to their children or others free of tax. In most cases, a two-share system involving a credit shelter trust will be the best option for helping clients save estate taxes. This common estate planning strategy splits the client’s estate into two shares at the death of the first spouse. These shares are often referred to as the Marital Share, which is intended to qualify for the marital deduction, and Family Share, which is intended to make maximum use of the unified credit.
The Marital Deduction (Marital Share)
The Marital Share is for the benefit of the surviving spouse alone during his or her lifetime. It can either pass to the surviving spouse outright or continue to be held in trust during his or her lifetime. If it remains in trust, the trust will typically be designed to provide for the surviving spouse during his or her lifetime, with the remainder to pass to the predeceased spouse’s beneficiaries at the death of the surviving spouse. Leaving the marital share in trust can achieve several purposes, including:
- Providing for the surviving during his or her lifetime;
- Shielding assets from the creditors of the surviving spouse (including a future ex-spouse);
- Avoiding the need to probate trust assets at the death of the surviving spouse; and
- Making sure the property is ultimately distributed as the client intends.
The Credit Shelter Trust (Family Share)
The Family Share is usually held in a credit shelter trust. Its purpose is to set aside an amount needed to take advantage of the unified credit that is available to the predeceased spouse’s estate. Credit shelter trusts are needed because transfers between spouses are not subject to estate tax and therefore cannot take advantage of the unified credit available to each spouse.
If the client leaves everything to the surviving spouse, his or her estate will not pay any estate taxes due to the unlimited married deduction. But the problem occurs at the death of the second spouse. The surviving spouse has only one unified credit. Everything over the unified credit amount (currently set to come back in at $1 million in 2011) will be subject to estate tax.
In other words, if the client’s estate plan leaves everything to the surviving spouse, the client’s unified credit will be wasted. Everything that the client leaves to the surviving spouse will be included in the surviving spouse’s estate. This will cause the combined estates of the client and his or her spouse to pay more taxes than necessary upon the second spouse’s death.
Good estate tax planning involves making use of both unified credits so that the married couple doubles the amount that they pass tax-free to their heirs. This is where the credit shelter trust comes in. It is designed to maximize the unified credit in each of the spouse’s estates. Instead of leaving everything to the spouse (and wasting the client’s unified credit), the client trust leaves part of the estate to the credit shelter trust. This amount is “sheltered” and is not subject to tax on the death of the second spouse. The goal of the credit shelter trust is to allow the surviving spouse to continue to use the assets of the trust during his or her lifetime while reducing the taxes paid in the couple’s combined estates.
An Illustration
Married Couple’s Estate Plan without Credit Shelter Trust
Suppose Husband and Wife have a combined taxable estate of $2 million. Let’s also assume that the unified credit is $1 million and the estate tax rate is a flat 55 percent. For sake of simplicity, we will assume that the marital assets are titled in Husband’s name alone and that Husband dies first, leaving his entire estate to Wife.
$2,000,000 Total Value of Husband’s Estate
$0 Unified Credit for Property Not Passing to Spouse
$2,000,000 Marital Deduction for Property Passing to Spouse
$0 Portion of Husband’s Estate that is Subject to Estate Tax
$0 Taxes Owed (Application of 55 Percent Tax Rate to Taxable Estate)
$2,000,000 Amount Left to Beneficiary (Surviving Spouse)
We see that, at Husband’s death, no estate taxes were owed. So far, this seems like a good result. But consider what happens at Wife’s death:
$2,000,000 Total Value of Wife’s Estate
$1,000,000 Unified Credit for Property Not Passing to Spouse
$0 Marital Deduction for Property Passing to Spouse
$1,000,000 Portion of Wife’s Estate that is Subject to Estate Tax
$550,000 Taxes Owed (Application of 55 Percent Tax Rate to Taxable Estate)
$1,450,000 Amount Left to Beneficiaries (Children)
When looking at the combined estates, we see that $550,000 of the couple’s marital assets end up being paid to the IRS, leaving only $1,450,000 for distribution to their children or other heirs. And, if we look at the Husband’s estate carefully, we see why. Because Husband left his entire estate to Wife, he didn’t use any of the unified credit that was available to him at his death. His $1 million unified credit was wasted.
Married Couple’s Estate Plan with Credit Shelter Trust
Let’s change the facts a little. Suppose Husband and Wife visit an estate planning attorney and have an estate plan prepared that incorporates a credit shelter trust. The amount placed in the credit shelter trust is available to support Wife during her lifetime, with the balance going to the children at death. It is designed to use Husband’s $1 million unified credit at his death and “shelter” that amount from inclusion in Wife’s estate. Let’s look at the results:
$2,000,000 Total Value of Husband’s Estate
$1,000,000 Unified Credit for Property Not Passing to Spouse
$1,000,000 Marital Deduction for Property Passing to Spouse
$0 Portion of Husband’s Estate that is Subject to Estate Tax
$0 Taxes Owed (Application of 55 Percent Tax Rate to Taxable Estate)
$0 Amount Left to Beneficiary (Surviving Spouse)
At Husband’s death, the result is the same as in the prior example—his estate does not pay estate taxes. But the amount that Husband left to the credit shelter trust is not included in Wife’s estate. Her estate is now valued at only $1 million. Now let’s look at what happens at Wife’s death.
$1,000,000 Total Value of Wife’s Estate (Excludes Husband’s Credit Shelter Trust)
$1,000,000 Unified Credit for Property Not Passing to Spouse
$0 Marital Deduction for Property Passing to Spouse
$0 Portion of Wife’s Estate that is Subject to Estate Tax
$0 Taxes Owed (Application of 55 Percent Tax Rate to Taxable Estate)
$1,000,000 Amount of Wife’s Estate Left to Beneficiaries (Children)
$1,000,000 Amount of Husband’s Credit Shelter Trust Left to Beneficiaries (Children)
$2,000,000 Total Amount Left to Beneficiaries (Children)
We can see that this is a much better result than the prior example. Instead of paying $550,000 to the IRS, Husband and Wife were able to leave the full $2 million value of their estate to their children. The substantial tax savings over the combined estates make credit shelter trusts an indispensable tool for married couples with taxable estates.