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Credit Shelter Trusts Remain Important to Estate Plans [CPA Journal, The](CPA Journal, The Via Acquire Media NewsEdge) Portability Has Its Limits For years, credit shelter trusts were regularly used as a basic estate tax planning technique for married couples. A typical credit shelter trust provides that assets up to the federal gift and estate tax exclusion ($5.34 million in 2014) are placed in trust and therefore "taxed" in the first spouse's estate. The assets remain in the trust for the benefit of the surviving spouse and are not subject to estate tax upon the surviving spouse's death. The balance of the estate passes to the surviving spouse or a marital trust and is not taxed due to the unlimited marital deduction. Without a credit shelter trust, if all assets were to pass to the surviving spouse, the first spouse's remaining gift and estate tax credit would be lost, resulting in a higher tax upon the death of the surviving spouse. The concept of portability (i.e., allowing a surviving spouse to utilize a deceased spouse's unused credit amount) was first introduced by the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010. Initially set to expire at the end of 2012, it was made permanent by the American Taxpayer Relief Act of 2012. The purpose of portability was to simplify estate planning for married couples with small to midsize estates. When estate and gift tax portability became permanent, many estate planning and investment professionals assumed it meant the end of credit shelter trusts. In many cases, however, credit shelter trusts still play a vital role in estate planning. Advantages of Portability Simplicity of planning. Portability provides valuable estate planning benefits to couples. Reliance on portability alone requires little or no formal planning. Spouses can leave their assets to each other and use the exclusion remaining from the first spouse on the second estate, without needing to create testamentary trusts for the surviving spouse. Assets do not have to be balanced between a husband and wife during their lifetimes, and there is no need to consider the tax implications of which spouse dies first or of simultaneous deaths. Ease of administration. Estates are easier to administer using portability. Because assets do not have to be placed in trust, the surviving spouse has complete control over the assets and the executor does not have to make decisions regarding trust funding. A timely estate tax return still must be filed, however, in order to preserve portability for the survivor. Second step-up. Appreciating assets can obtain a second step-up in basis upon the death of the surviving spouse. Assets placed in a credit shelter trust are not included in the estate of the survivor, so they do not receive a step up in basis upon the survivor's death. For appreciable assets (such as businesses or real estate) that are likely to be sold by the beneficiaries rather than held long-term, this second step-up can add tremendous value, especially in light of high capital gains tax rates and the 3.8% net investment income tax (NIIT). Example Consider the following example. Henry and Wendy are a married couple living in New York with $15 million in combined assets at Henry's death on January 1,2012. They made no taxable gifts during their lifetimes. Henry had a $5 million building in his name alone. The couple had $10 million in jointly held assets, which pays for their expenses. Upon Wendy's death on December 31, 2013, the building was worth $7 million and had accumulated $1 million of income since Henry's death. Assume Henry made a will leaving everything to Wendy, with no credit shelter trust. Under the portability rules, Henry's unused exclusion of $5.12 million (2012 amount) is added to Wendy's estate's exclusion of $5.25 million (2013 amount) to pass $10.37 million free of federal estate tax. This results in a $4.46 million estate tax (combined federal and New York State) on Wendy's estate, now worth $18 million. Had Henry set up a credit shelter trust in his will and had the trust been funded with file building (with the income staying in trust), the building would not be taxed in Wendy's estate, leaving her estate at $10 million. This would result in a combined federal and New York State estate tax of $2.34 million. Note that this would have required Henry's estate to pay $391,600 in New York State estate tax upon his death, so the total tax paid from their combined estates would be $2.73 million, a savings of $ 1.73 million over using portability alone. The $1.73 million estate tax savings comes with a capital gains tax tradeoff: the basis in the building is not stepped up on Wendy's death, so the heirs would have a $7 million property with a $5 million basis (the value as of Henry's death). The heirs would have a substantial capital gains tax due upon the sale of the property, but the property would continue producing income in the meantime. There is less estate tax due upon Wendy's death, when cash may or may not be available. The capital gains tax is only due in the event of a sale, when cash is usually available. If the heirs hold the building long-term, or defer the gain via an Internal Revenue Code (IRC) section 1031 exchange, the lower cost basis is less detrimental. Concerns About Relying on Portability Valuation date and growth. Using portability, assets are valued for tax purposes as of the death of the last spouse to die. Any increase in the value between tiie death of the first spouse and the death of the second spouse can increase the estate tax. The unused exclusion is not indexed for inflation when added to the surviving spouse's credit. With a credit shelter trust, tiie value for estate tax purposes is determined at the death of the first spouse. This is preferable for assets that are likely to increase in value or generate substantial income, because this increase occurs free of estate tax. Federal GST tax exemption. The federal generation-skipping transfer (GST) tax exemption is not portable. For families that want to pass assets down multiple generations in a tax-efficient manner, spouses cannot simply leave everything to one another and rely on portability. Lifetime transfers, testamentary trusts, or a combination of the two can make full use of the GST tax exemption. To return to the example, Henry can structure a credit shelter trust so that up to $5.12 million would be held in trust for his wife Wendy and their children during their lifetimes and then distributed to his grandchildren free of federal GST tax. This generation-skipping trust would not be taxed in the estates of Henry's children. Estate tax return still required. Even if a federal estate tax return is not otherwise required to be filed because the first spouse's estate is below the federal estate tax exclusion, a return must nevertheless be filed in a timely manner to take advantage of portability. If a return is not filed, the benefits of portability could be lost. Loss of portability upon remarriage. In the event of a remarriage, the surviving spouse may lose the first spouse's unused exclusion. A person is only allowed to carry over the unused exclusion of the last predeceased spouse. For example, if Wendy remarries and her new spouse Hector uses up his entire credit and then dies before Wendy, Wendy's entire $18 million estate would be subject to estate tax. Henry's unused exclusion would disappear, because he was not her last predeceased spouse. This would cause an estate tax of $6.51 million (as opposed to the $2.73 million Henry would have used as a credit shelter trust). New York State estate tax mismatch. New York State does not have an estate tax portability provision. If all of the assets pass to the surviving spouse upon the death of the first spouse, any New York State estate tax exclusion (currently $2,062,500) is lost. In the example, Wendy's estate would be $18 million, with a $4.46 million tax. If Henry had set up a credit shelter trust using only New York's $1 million estate tax exclusion that was in effect as of 2012, he could have transferred a 20% interest in the building into the trust (without considering marketability and minority discounts). Wendy's estate's combined federal and state estate tax would have been $4.07 million, a savings of $390,000 over using pure portability. No federal or state estate tax would be due upon Henry's death. The recent overhaul of New York's estate tax law has made credit shelter trusts even more valuable for married couples in New York with significant taxable estates. Because New York's estate tax rates are graduated, paying estate tax on the first estate at the lower rates can potentially reduce the tax on the combined estates. General Benefits of Testamentary Trusts In addition to the possible tax benefits of using a credit shelter trust, there are other advantages to using trusts as part of an estate plan. Multiple marriages. If a surviving spouse remarries, the trust documents retain the joint planning of both spouses. For example, if Henry does not leave his estate in trust, upon his death, Wendy is free to dispose of the assets as she pleases. She can change her will to include a new husband or she can cut out the children from her marriage to Henry altogether. If Henry had children from a prior marriage, he would likely want to establish a trust to prevent Wendy from cutting Henry's children out of an inheritance. Asset management A surviving spouse may be incapable of managing assets. People who are losing their faculties can be influenced to make gifts favoring one child over another. A trust appoints a trustee to oversee, safeguard, and administer the trust's assets. The trust can contain restrictions on investments, guidelines for making distributions for beneficiaries, and provisions allowing the trustee to use the trust's assets to provide for the surviving spouse's well-being. Creditor protection. Trusts give surviving spouses creditor protection that is not available through portability. The laws of New York and other states contain "spendthrift" provisions that generally do not allow the creditors of trust beneficiaries to attach trust assets. If drafted for maximum asset protection and trustee discretion, trust beneficiaries have no right to demand the funds in trust over the trustee's objection. Upon the death of the surviving spouse, assets can remain in further trust, with the same benefits for children, grandchildren, and later generations. Future of Estate Planning At first glance, portability may seem to eliminate the need for formal estate planning for the moderately wealthy. The ability to move a deceased spouse's unused exclusion amount to the surviving spouse prevents the complete wasting of the deceased spouse's unified credit without the need for a credit shelter trust. When planning an estate, however, legal, tax, and financial professionals need to consider the impact of portability on each client in light of individual circumstances. Credit shelter trusts still offer a variety of advantages, and their importance in estate planning should not be overlooked. John P. Gordon, JD, is an associate in the trusts and estates practice group of Vishnick McGovern Milizio LLP, Lake Success, N.Y. (c) 2014 New York State Society of Certified Public Accountants |