Richard English, J.D., Managing Director-West Region, Commerce Family Office
What is a credit shelter trust?
Traditional estate planning for married couples has long included the use of an irrevocable trust, created at the death of the first spouse to die, and funded with the amount of the deceased spouse’s unused exemption from federal estate taxes. Such a trust has been referred to by many different names, including a “non-marital” trust, an “estate tax exemption” trust, or a “credit shelter” trust. In many cases, it is referred to in the trust’s governing document simply by a letter, such as A, B, C, or D, depending on the wording of the trust instrument. For these purposes, we will refer to this type of trust as a “credit shelter trust.”
For many years, the primary reason to create a credit shelter trust was to avoid “wasting” the estate tax exemption of the first spouse to die. At the first spouse’s death, the trust is funded with the remaining amount of the deceased spouse’s federal estate tax exemption and any assets in excess of that amount pass either to a “marital deduction” trust or outright to the surviving spouse.
The net result is no estate tax at the first spouse’s death, and deferral of any estate tax to the second spouse’s death, at which point the tax would be imposed on the assets in the second spouse’s taxable estate, but not on the value of the credit shelter trust.
What is portability?
With certain limitations, when one spouse dies, the “deceased spousal unused exclusion amount” (DSUEA) becomes “portable” to the surviving spouse. Because many married couples historically may not have prepared an adequate estate plan, the estate tax exemption for the first spouse to die went unused. As a result, at the death of the second spouse, the estate tax liability was based on the second spouse’s individual exemption only. In 2010, Congress adopted the concept of estate tax “portability.” Starting in 2011, the estate of a husband or wife whose spouse died that year was allowed to use any unused estate tax exemption of the deceased spouse in addition to their own exemption amount.
While portability might be viewed as a reason to do away with credit shelter trusts, there are certain limits to portability and certain advantages to credit shelter trusts. Accordingly, portability is often viewed as a “fallback” alternative tax strategy.
Why choose a credit shelter trust over portability?
Capturing the exemption at the first death: The credit shelter trust is designed to capture the amount of the first spouse’s federal estate tax exemption at the time of the first death. As a result, all of the appreciation in the value of that trust occurring between the first death and the second death will escape estate taxation at the second death. With portability, however, the DSUEA is “frozen” at the first death and applied at the second death against the value of the second spouse’s estate. Because the DSUEA does not grow after the first death, a credit shelter trust generally allows more value to escape estate taxation than does portability, assuming the assets grow in value between the two deaths.
Assets in a credit shelter trust are protected: Funding a credit shelter trust at the first spouse’s death can provide a certain degree of protection to the surviving spouse and any remainder beneficiaries. The spouse (and in some cases, the couple’s descendants) can receive income generated by the trust and principal distributions within standards set forth in the trust document, such as health, education, maintenance, and support. However, during the surviving spouse’s life, the trust assets will likely be protected from the claims of any creditors, or from the efforts of others to defraud the surviving spouse.
Providing for children at the first death: Many credit shelter trusts will allow for income and principal distributions to the surviving spouse and the couple’s children. Alternatively, the spouse can be the sole beneficiary during his or her lifetime, providing for children only at the death of the second spouse.
Better vehicle for generation-skipping planning: For those who are interested in creating long-term trusts for their children and grandchildren, the credit shelter trust is generally a better choice than portability planning. While the estate tax exemption is “portable,” the generation-skipping transfer tax exemption is not. As a result, if a married couple wants to get as much value as possible into trusts that will transfer tax-free for their children and more remote descendants, portability is not a good option.
Why choose portability over a credit shelter trust?
Simplicity: A plan to rely on portability is fundamentally simple. The first spouse to die can just leave all of his or her assets to the surviving spouse. That is easy to do, and it affords the surviving spouse maximum flexibility in dealing with those assets. A credit shelter trust, on the other hand, requires more planning and work.
Stepped-up basis at second death: If the second spouse to die owns all of the couple’s assets at death, then all of the assets will receive an adjustment to cost basis (often called a “step-up”) at the second death. With a credit shelter trust, however, there will usually be no adjustment to the cost basis of the assets inside the trust at the second death. In either case, there will be an adjustment to cost basis at the death of the first spouse for any assets owned by that spouse, which can significantly reduce capital gains taxes if the assets are later sold.
No additional tax return: Once a credit shelter trust is funded, the trustee of that trust will have to file a fiduciary income tax return (Form 1041) every year. This will usually not be the case with portability, because the second spouse owns all of the couple’s assets and can handle all of the necessary tax reporting through their federal and state personal income tax returns.
Considerations
Estate tax return required for portability: To calculate and capture the DSUEA at the first death, the estate of the first spouse must file a federal estate tax return (Form 706) even if not otherwise required. Through some special rules that apply to portability, if an estate is not otherwise required to file such a return, the IRS allows five years after the first death to make that filing to elect for portability, which is much longer than the nine-month deadline for estates that are required to file.
Be sure your estate planning documents are current: Because portability is a relatively new concept and because the estate tax exemption amount has increased so dramatically in recent years, it is prudent to have older estate planning documents reviewed periodically and updated as needed to ensure that they still meet your expectations. Some people are still relying on a plan that might have made sense with a much lower exemption but could provide unintended results with a large exemption amount.
Remarriage can complicate things: Portability allows the surviving spouse to use the DSUEA of the most recently deceased spouse. As a result, if a surviving spouse wishes to remarry but was planning to use the deceased spouse’s DSUEA, the surviving spouse should seek out thoughtful advice about the impact of remarriage on his or her plans.
Example of estate and generation-skipping transfer tax planning with a credit shelter trust:
Ray and Deborah have put off meeting with an estate planning attorney for many years, even though they have three children and a sizable estate. They are interested in keeping things simple and want to own everything jointly so the surviving spouse will own everything after the first death.
However, they have also accumulated substantial wealth and wish to leave their estate in long-term, generation-skipping trusts for their descendants. After consulting their wealth management team and meeting with their attorney, they decide not to rely on portability, but to provide for the creation and funding of a credit shelter trust at the death of the first spouse. By using this approach, Ray and Deborah can minimize their estate and generation-skipping transfer taxes to preserve their wealth for future generations.
Comprehensive estate planning strategies from Commerce Trust
While a credit shelter trust can be an impactful estate planning tool for estate tax reduction and generation-skipping wealth transfer, its efficacy depends on careful consideration of your financial goals and a thorough understanding of applicable laws. At Commerce Trust, our wealth management teams are comprised of specialists across multiple disciplines who can help you determine which estate planning strategies best support your comprehensive estate plan. If that includes establishing a trust, we will prepare you to meet with an estate planning attorney by providing holistic guidance in advance and can work closely with them on an ongoing basis to achieve your unique objectives. Contact Commerce Trust today if you want to learn more about our private wealth management and estate planning services and how we can help you incorporate a trust into your estate plan.
The opinions and other information in the commentary are provided as of August 15, 2024. This summary is intended to provide general information only, and may be of value to the reader and audience.
This material is not a recommendation of any particular investment or insurance strategy, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified tax advisor or investment professional. While Commerce may provide information or express opinions from time to time, such information or opinions are subject to change, are not offered as professional tax, insurance or legal advice, and may not be relied on as such.
Commerce Trust does not provide tax advice to customers unless engaged to do so. Commerce Trust does not provide legal advice to its customers. Consult an attorney for legal advice, including drafting and execution of estate planning documents.
Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Commerce Trust is a division of Commerce Bank.
Investment Products: Not FDIC Insured | May Lose Value | No Bank Guarantee