Credit Shelter Trust

The term Credit Shelter Trust might sound like a complicated estate planning maneuver, but it doesn’t have to be.

Quite simply, a Credit Shelter Trust is a way for married couples to avoid paying out significant estate taxes by “sheltering” the maximum amount of money permitted under the estate tax exclusion in a trust. Estate tax law has been shaken up quite a bit in recent years, so it’s important to remember that this area of law is in flux and is likely to change in the near future.

A Credit Shelter Trust is created upon the death of one spouse. This type of irrevocable trust is also known as an AB Trust or Marital Bypass Trust. These terms are interchangeable and simply refer to a trust designed to take full advantage of the federal estate tax exclusion of both husband and wife. It is also possible to use a testamentary trust – a trust set forth within the body of a Last Will and Testament – to create a Credit Shelter Trust. (See living trust taxes.) Even though a Credit Shelter Trust must be irrevocable in order to be excluded from the surviving spouse’s estate, he or she is still entitled to:

• Function as trustee,
• Receive all trust income,
• Withdraw up to 5% of the principal per year,
• Withdraw payments for support, health, education, and maintenance,
• Authorize distributions of the principal to recipients other than himself or herself.
  

Here’s how it works:

Assume a married couple has a total of $2 million in assets. Upon the death of the first spouse, $1 million is transferred to a Credit Shelter Trust and $1 million to the surviving spouse. Both transfers are tax free. The direct transfer to the surviving spouse is tax free under the unlimited marital deduction. The surviving spouse has access to the Credit Shelter Trust for the rest of his or her lifetime. When the second spouse dies, the assets in the Credit Shelter Trust can be transferred to other beneficiaries with no estate tax. The trust assets transfer tax free to the beneficiaries because the first spouse used his or her $1 million estate tax exclusion on the trust. See Estate Tax for further information about estate tax rules.

Without a Credit Shelter Trust, either through a revocable living trust or a testamentary trust, the first spouse would have died leaving the survivor a total of $2 million. Upon the death of the second spouse, the estate now has $2 million and an estate tax exclusion of only $1 million. That leaves an estate tax bill of 45% of $1 million or $450,000 – money that could have gone to beneficiaries had a simple Credit Shelter Trust been in place.

In 2010, Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (TRA). For anyone who died in 2011 or 2012, the federal estate tax exemption is $5.12 million with a 35% federal estate tax rate. There was no federal estate tax in 2010, prompting the joke that, for tax planning purposes, 2010 was the best year for millionaires to die. Unless the law changes, the federal estate tax exemption for 2013 will jump back down to $1 million with a 55% federal estate tax rate. Also under TRA, any unused federal estate tax exemption is deemed “portable”, meaning it can be passed along to a surviving spouse.

Technically, this does away with the need for Credit Shelter Trusts. This so-called portability should be viewed with an abundance of caution, however, because right now it only applies to those persons who died in 2011 or 2012. A surviving spouse wishing to take advantage of the unused exemption must also file a federal estate tax return, which is costly and requires expert assistance. It is probably a better idea to invest the money in setting up a Credit Shelter Trust, which will protect assets regardless of any upcoming changes in the law.

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