One of the more interesting debates in estate planning circles these days surrounds so-called credit shelter trusts – also known as A-B Trusts or marital and bypass trusts, respectively. These are trusts set up as a way to preserve the full amount of estate tax exemption between a husband and wife.
So, for example, when the tax rules said that each person could pass $1 million on to heirs exempt from estate taxes, a family with, let’s say, $2 million in total assets had several choices. When the first spouse died, all the money could go to the second spouse. But then, when the second spouse died, $1 million–plus whatever appreciation those assets enjoyed between the first and second death–would be subject to estate taxes. The first spouse’s $1 million exemption would be lost.
Alternatively, you could preserve the $1 million exemption by leaving that amount to heirs when the first spouse died. But this might diminish the lifestyle of the surviving spouse.
The third possibility is for the estate planner to arrange that when the first spouse dies, $1 million of assets (the full exemption amount) would be transferred to a credit shelter trust. The living spouse would be beneficiary of the trust and permitted to take income from the trust until death, so the trust wouldn’t cause impoverishment. When the second spouse died, the trust assets–and any appreciation–would go to the heirs free of estate taxes, and the full exemption amount would be preserved.
So why is this strategy that has been commonplace for decades controversial today? First, Ohio has no more state estate tax as of this year. Previously the exemption was $338,333 and with the relatively low exemption applied to many estates. Before 2013, using a credit shelter trust could save more than $20 thousand in state estate taxes alone.
Second, the federal estate tax exemption is not $1 million, but $5.25 million per spouse in 2013, which means many people won’t have to worry about estate taxes when they die. Also, the federal exemption amount is portable. That means when the first spouse dies, she could leave her assets to her surviving husband, and he would also inherit her $5.25 million exemption. The full $10.5 million joint exemption would be preserved without having to set up a fancy trust vehicle or any other estate planning footwork.
It’s important to note that to take advantage of the portability rule, an estate tax return must be filed when the first spouse dies–even if no tax will be due. As commentators have pointed out, this means the IRS must process returns that don’t provide any tax revenue, and taxpayers must pay experts to prepare these complicated tax returns.
Despite the increased compliance costs, many couples will no longer need Bypass Trusts. Simply leaving everything you own to your spouse can be just as effective to preserve the first spouse’s estate tax exemption. For a very large number of couples, simple “I Love You Wills” (as in, “Honey, I love you, and I leave you everything”) will be sufficient to cover the bulk of their estate tax planning.
This is good news; estate planning just got simpler. Now you can spend more time in the estate planning process talking about where you actually want money to go after death and how it should managed, rather than being forced to spend a great deal of time talking about “complex” trusts solely for the purposes of working around the estate tax exemptions.
Of course, many couples may still wish to explore trust planning for other reasons, including asset protection, controlling where assets go after death, limiting a surviving spouse’s access to assets, or for generation-skipping-trust planning.
For example, in a blended family where each spouse brings children to the marriage, the credit shelter trust would name the deceased spouse’s children as the beneficiaries, potentially preventing a situation where the surviving spouse would inherit all the assets and then leave everything to his or her children. And the money in the credit shelter trust is protected from creditors.
There’s another benefit as well. Suppose the husband dies, the full $5 million is transferred to the wife, and the wife remarries. If the new husband dies before the wife–which is not unlikely–then the wife would get the second husband’s credit and lose the first husband’s. If the second husband has already used some or all of his exemption, then the wife loses the portable exemption she inherited. A credit shelter trust takes away some or all of that risk.
Clearly, a credit shelter trust is not for everybody. And clearly, the relatively high estate tax threshold means that many people won’t have to worry much about these things. But for some people, in some situations, they may still make sense.
Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs.
