Credit Shelter Trusts Aren’t Just for the Super Wealthy

Credit shelter trusts are a way to take full advantage of state and federal estate tax exemptions. Although such trusts may appear needless unless you are a multi-millionaire, there are still reasons for those of more modest means to do this kind of planning, and one of the main ones is state taxes.

The first $11.7 million (in 2021) of an estate is exempt from federal estate taxes, so theoretically a husband and wife would have no estate tax if their estate is less than $23.4 million. The estate tax is also “portable” between spouses. This means that if the first spouse to die does not use all of his or her $11.7 million exemption, the estate of the surviving spouse may use it (provided the surviving spouse makes an “election” on the first spouse’s estate tax return).

However, if one spouse dies and leaves everything to the surviving spouse, the surviving spouse may have an estate that is greater than $11.7 million plus whatever is left over from the deceased spouse’s exemption, or an estate that is higher than the applicable threshold in his or her state (assuming the state has an estate or inheritance tax). When the surviving spouse dies, any part of the estate over that threshold will be subject to estate tax. In other words, without proper planning the exemption of the first spouse to die is lost. The way to preserve both spouses’ exemptions has been to create a “credit shelter trust” (also called an A/B or bypass trust).

Many states have an estate or inheritance tax and the thresholds are usually far lower than the current federal one. Let’s say that a couple lives in State X, which has retained an estate tax on all estates over $1 million (this is the state’s exemption). Looking at just the federal exemption of $11.7 million (in 2021) and the ability for the first spouse to die to transfer his or her unused credit to the other spouse, it would appear that the couple would have no tax issues if their estate is under $11.7 million. However, if the first spouse on his death passes everything to the surviving spouse, she may end up with an estate well over the state’s $1 million threshold and be subject to a substantial state tax upon her own death. In effect, the couple has lost the state’s “unified credit” of the first spouse to pass away.

Standard estate tax planning is to split an estate that is over the prevailing state or federal exemption amount between spouses and for each spouse to execute a trust to “shelter” the first exemption amount in the estate of the first spouse to pass away.  While the terms of such trusts vary, they generally provide that the trust income will be paid to the surviving spouse and the trust principal will be available at the discretion of the trustee if needed by the surviving spouse. Since the surviving spouse does not control distributions of principal, the trust funds will not be included in her estate at her death and will not be subject to tax. This way, in State X the couple can protect up to $2 million from estate taxation while still making the entire estate available to the surviving spouse if needed.

The rising federal estate tax exemption means that many older trusts drawn up for married couples contain outdated estate-splitting provisions that may cost them dearly in state or federal taxes, or both. Couples would do well to have their revocable trusts that contain credit shelter provisions reviewed by a competent professional.

Even if your state has no estate or inheritance tax, there are other reasons to have a credit shelter trust, including the following:

• It shields funds in trust from creditors
• It protects children’s inheritance if the surviving spouse remarries
• It helps avoid administrative headaches
• Congress can decide to change the estate tax