Credit Shelter Trusts: Mastering Estate Tax Minimization
Minimizing Taxes in Very Large Estates
Before the introduction of portability, the principal purpose of a credit shelter trust (otherwise known as a bypass trust) was to allow couples to leverage both spouses’ exemption amounts against the estate tax. Without the trust, the exemption amount of the first spouse to die would be lost if the estate passed directly to the surviving spouse. Portability now eliminates the need for a credit shelter trust for this purpose except in very large estates.
Let’s look at an example of an estate where a credit shelter trust would still be useful. Aaron dies and leaves his $14 million estate to his wife, Rebecca. These assets are protected by the unlimited marital deduction, so Rebecca doesn’t have to pay taxes on them. With the addition of Aaron’s assets, Rebecca now has a $20 million estate, which still falls under their combined $25.84 million exemption (in 2023).
However, when Rebecca dies 15 years later, that $20 million has increased in value to $36 million, leaving a significant portion exposed to estate tax. If Aaron had used a credit shelter trust to pass his $12.92 million (in 2023) on to Rebecca, her estate could have reduced or avoided the estate tax, since the growth of the assets in the trust would not affect Rebecca’s estate.
How Does a Credit Shelter Trust Work?
Let’s assume Aaron uses a credit shelter trust to protect family assets. When Aaron dies, his will divides the estate into two parts:
- A part of the estate equal to the exemption amount goes into the credit shelter trust. Not only is this original amount sheltered from the estate tax, so is any increase in value, even if it ultimately exceeds the exemption amount at Rebecca’s death. Rebecca has full rights to the income from the trust, but limited access to the trust principal. When Rebecca dies, the trustee distributes the property to family beneficiaries—in this case, Aaron and Rebecca’s two children.
- The remainder of the estate goes directly to Rebecca and is sheltered by the unlimited marital deduction (plus any unused exclusion amount left over from Aaron’s death). Or, if Aaron prefers, he can direct this portion into a marital trust for Rebecca’s benefit.
As mentioned, in light of the high exemption amount and portability, this type of trust is only useful for federal estate tax minimization for the largest of estates.
In addition, grantors usually fund a credit shelter trust to the amount of the exemption, but that is a substantial amount of money to remove from the share going directly to the surviving spouse. Of course, the grantor can limit the amount that goes into the trust if it makes planning sense.
Another potential downside is that the surviving spouse cannot control the final disposition of the trust assets. The trust terms are dictated by the first-to-die spouse.
Despite the downsides, a credit shelter trust may still be useful for:
- minimizing the estate tax in very large estates where portability may not be enough, especially if those assets are expected to grow
- avoiding transfer taxes on future appreciation of trust assets
- protecting assets from creditors of the surviving spouse
- securing professional money management for trust assets
- implementing spendthrift provisions
- ensuring that trust assets will eventually benefit family members or loved ones of the surviving spouse—not the spouse of a second marriage or that new spouse’s family
- minimizing the generation-skipping transfer tax (to which portability does not apply)
Making It a Family Affair
An individual can choose to make a credit shelter trust into a sprinkling trust. This entails giving the trustee (or the surviving spouse) the power to “sprinkle” the trust income (and maybe also the principal) among several beneficiaries, not just the surviving spouse.
This is a good option if the spouse is already in a relatively high-income tax bracket. It can substantially reduce the family tax burden while still keeping all the trust income in the family. However, while this offers additional flexibility, to preserve the estate tax benefits of the trust, the surviving spouse can only be granted the power to sprinkle income to others.
Going back to the example of Aaron and Rebecca, Aaron might choose to give Rebecca a sprinkling of power when he sets up the trust. This would free him from the responsibility of irrevocably determining the eventual distribution of the trust income and principal before all the facts are in.
What if one child needs financial assistance sooner than the other? With a sprinkling power, Rebecca could take such needs into account after Aaron died. However, Aaron would have to ensure that Rebecca was not able to sprinkle any income to herself or in any way for her own benefit.