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Wills · Living Trusts · Probate Law ·
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A Credit Shelter Trust is a receptacle for
property that will pass tax free to descendants or other beneficiaries because
of the federal estate tax exemption, currently $1,000,000 - and increasing until
it is phased out in the year 2010. As with any trust, the Credit Shelter
Trust provides flexibility in making distributions to beneficiaries, including
the ability to take into account special circumstances and needs of
beneficiaries arising subsequent to drafting or amending the trust. It can
optionally provide additional tax minimization and debtor protection features
for beneficiaries as with Spendthrift and Special Needs Trusts and Generation
Skipping Trusts (discussed below).
The Credit Shelter Trust has advantages for married persons. It allows the
surviving spouse as primary beneficiary to benefit from the trust without the
property being included in her estate, and hence taxed, at her death. For this
reason it is sometimes referred to as a Bypass Trust. Children or other
descendants are usually specified as remainder beneficiaries. The Credit Shelter
Trust concept applies as well to primary beneficiaries other than surviving
spouses. The credit shelter trust is also sometimes referred to as the family
trust.
The trust is funded during
life or at death with property titled in the decedent's name. It is normally
funded up to the estate tax exemption amount. Funding above this amount is
sometimes done in large estates to equalize spouses marginal estate tax rates,
thereby reducing combined tax exposure. If the trust is funded during the
donor's life it removes subsequent appreciation of the funds from his estate
(thereby reducing exposure to transfer taxation).The trust can be structured so
the donor pays the income taxes on trust earnings - providing additional
transfer tax relief.
To qualify
for bypass treatment beneficiary interests in the trust must be limited.
Beneficiaries can have the income of the trust, any additional amounts required
for health, support, education and maintenance, the greater of $5,000 or 5% per
year of the trust principal, and a limited right to select remainder
beneficiaries. If more flexibility is needed an independent trustee or a
remainder-beneficiary cotrustee can be used to provide additional amounts from
the trust corpus.
If the primary
beneficiary is unlikely to need benefits from the trust it can be disclaimed if
done in a timely manner thereby allowing the property to pass directly to
remainder beneficiaries. This would avoid taxation in the estate of the primary
beneficiary of trust proceeds otherwise required to be distributed to the
primary beneficiary according to the terms of the trust. Alternatively, an
independent trustee can be used to provide flexibility in allocating Bypass
Trust benefits among beneficiaries. Another option would be to leave the
surviving spouse (or other primary beneficiary) out of the Bypass Trust
altogether. The advantage is that it wouldn't depend on the beneficiary timely
executing a valid disclaimer.
At
the other extreme is a situation where the primary beneficiary's resources may
be so limited that she is likely to need all the Bypass Trust property during
her life. In this case the Will or Living Trust document can specify that the
Bypass Trust is to be funded (i.e., created) only in the event the primary
beneficiary disclaims an outright bequest. Thus, upon the death of the donor, if
the primary beneficiary found she needed all the bypass property during her life
she would simply accept the outright bequest. Otherwise, she could disclaim and
the Bypass Trust would be created and funded - giving her protection in the
future if her own resources became depleted.
The decedent spouse's estate over
and above the amount that funds the Bypass Trust can pass tax-free either
outright or in trust to the surviving spouse because of the unlimited marital
deduction. Marital deduction assets thereafter remaining in the surviving
spouse's estate at her death are subject to estate tax. The result of using a
Bypass Trust and the marital deduction is that all federal estate taxes can be
avoided in the estate of the first spouse to die, and the property remaining in
the Bypass Trust at the surviving spouse's death escapes taxation in her
estate.
When the Bypass Trust, the
marital deduction and both spouses' estate tax exemptions are utilized $2.0
million (in 2002) can ultimately be transferred to children and other
beneficiaries free of federal estate taxes. The amount increases as a result of 2001
legislation as follows: 2002-2003, $2,000,000; 2004 and 2005, $3,000,000; 2006,
2007 and 2008, $4,000,000; 2009, $7,000,000; 2010,
unlimited.
When should the decedent
spouse pass marital deduction property to the surviving spouse in trust rather
than outright? A trust can provide the following: 1) more control over the
ultimate disposition of the property, 2) more flexibility in making beneficiary
distributions, 3) protection from trade and judgment creditors, and 4) multiple
generation tax minimization.
To
qualify for the marital deduction the trust must provide that the surviving
spouse is entitled to at least the income of the trust for life. The trust can
optionally provide the spouse with any amounts over and above the income as
desired. The two most common types of marital deduction trusts are the
Testamentary QTIP (qualifying terminable interest property) Trust and the Life
Estate with Power of Appointment
Trust.
When it is desirable to
prevent a potential diversion of assets from the decedent's family, such as may
occur in the case of the surviving spouse's remarriage or children from a
previous marriage, a QTIP Trust can be used. In addition to providing the
surviving spouse the income from the trust during her life the QTIP Trust can
optionally provide her with the greater of $5,000 or 5% of the principal of the
trust each year, any additional amounts required for her health, education,
maintenance and support, and the power to specify remainder beneficiaries of the
trust (except she cannot name her estate or her creditors as
beneficiaries).
The Power of
Appointment Trust, on the other hand, gives the surviving spouse more control
over the trust property. This type of marital deduction trust can allow her to
specify the ultimate beneficiaries and/or make discretionary distributions (to
herself and others) during her life. One advantage of this trust is it allows
the surviving spouse to make annual exclusion gifts to children out of trust
property to reduce her estate tax
exposure.
Using a QTIP Trust
enables the executor to elect to qualify all or a portion of the trust for the
marital deduction. This may be desirable, for example, when the surviving
spouse's estate would likely be taxed at a higher marginal estate tax rate if it
included the decedent spouse's entire estate over his tax free credit shelter
amount. Instead, the executor would elect to have part of the QTIP Trust taxed
in the decedent spouse's estate.
If it is desirable to remove marital trust income from exposure to taxation in
the surviving spouse's estate a disclaimer may be utilized. If a trust naming
the surviving spouse and children as beneficiaries is to receive the disclaimed
property there are limits on the surviving spouse's ability to retain certain
rights in the trust.
For estate tax purposes it is
desirable to title a married couple's property in such a manner that if either
one predeceases the other the deceased spouse can utilized her estate tax
exemption and thereby pass that amount of their combined estate free of tax to
children. In order to do this the married couple must title property in each
person's name.
In some cases the
breadwinner-spouse may be reluctant to transfer property to his spouse outright
for this purpose. This could be due to a concern over a possible divorce or
because of the other spouse's financial history. (Generally, however, the
divorce issue would only arise where the property being transferred was not
already part of the marital estate, as in the case of inherited property or
property acquired prior to the marriage which is kept separate from the marital
estate.)
A Lifetime QTIP Trust can
utilize the non-breadwinning spouse's estate tax exemption without giving the
spouse complete control over the transferred property. As with a testamentary
QTIP Trust the spouse must at least receive the trust income.
Generation skipping transfer taxes
apply to transfers which skip a generation, as with transfers to grandchildren.
They are in addition to estate taxes. The first $1,030,000 transferred is exempt
from generation skipping taxes. Over that amount generation skipping transfers
are taxed at the maximum marginal estate tax rate (currently
50%).
A Generation Skipping Trust
is an irrevocable trust designed to utilize this exemption in a manner which
benefits multiple generations. This is accomplished by limiting distributions
from the trust based on specified needs or purposes, such as to provide
healthcare, education, maintenance or support, or by having an independent
cotrustee serve with authority to make additional, discretionary
distributions.
Depending on where
the trust is set up and how well the trust investments perform, it can continue
in perpetuity as a dynasty type of trust, or terminate within 21 years after the
death of the last beneficiary alive at the time the trust commences. These
trusts are set up during life through the use of an irrevocable trust or arise
at death by virtue of Living Trust or Will
provisions.
If your children are
likely to incur estate taxes at death, or are unlikely to need benefits from
your estate after your death, the Generation Skipping Trust may be advisable to
provide a foundation for the needs of multiple-generation descendants such as
for healthcare, education or support. These trusts can permit the trustee to
make discretionary distributions to your immediate children if
needed.
Normally, annual exclusion
gifts to grandchildren are not charged against the $1,030,000 generation skip
exemption. However, they will be charged against the exemption if the gifts are
made in trust unless the trust is solely for the benefit of one grandchild (one
trust for each grandchild) and the assets of the trust are included in the
grandchild's estate at death. The sooner you transfer to grandchildren the
better since post transfer appreciation will not be charged against the
exemption if a timely election is made.
A Crummey Power Trust is an
irrevocable trust designed to qualify contributions as nontaxable annual
exclusion gifts while limiting access by the beneficiaries to the trust
property. This is done in order to control the amount and timing of
distributions to provide for the beneficiaries well being over time. Qualifying
annual exclusion gifts to the trust are a multiple of the number of trust
beneficiaries, including in some cases contingent remainder beneficiaries (i.e.,
a $20,000 transfer to a trust with two beneficiaries qualifies as a $10,000
annual exclusion gift to each beneficiary). The trustee should be someone other
than the donor or someone under his
control.
In most circumstances,
beneficiaries go along with the donor's plan to have the funds stay in trust,
but they must be notified of the gifts and have the right to withdraw the
contributions within a limited time period (usually 30 days). After the
withdrawal period the terms of the trust determine when any distributions are
made to beneficiaries. The Crummey Power Trust can serve as an Irrevocable Life
Insurance Trust (see below).
Like the Crummey Power Trust this
type of trust is irrevocable, can serve as a receptacle for insurance on the
life of the donor, and can qualify for the annual gift tax exclusion (if the
trust provides that funds can be used for the minor's benefit if needed). Unlike
the Crummey Power Trust, however, the 2503(c) Trust can have only one
beneficiary and there is no need to notify the beneficiary of contributions.
The assets in the trust must be
distributed when the minor reaches 21 unless it provides a limited withdrawal
period (commonly 30 to 60 days) upon the minor's 21st birthday, after which
amounts not withdrawn can continue to be held in trust. Alternatively, the
trustee can purchase an annuity and give it outright to the minor at the age of
21, thus effecting a desired payout over
time.
The advantages of the
2503(c) Minor's Trust trust are twofold: potentially lower income taxes on
family assets and reduced exposure of the donor to gift and estate
taxes.
An alternative to the
2503(c) Trust is titling the gifts in the name of an adult as custodian of the
minor under the Uniform Transfers to Minors Act or similar local law. Although
this may be simpler than the 2503(c) trust it is less flexible because it must
end, and the funds must be distributed to the minor, when the minor reaches the
age of majority. Furthermore, if the custodian is a parent the proceeds would be
included in the parent's estate at his death because he could have used the
funds to fulfill his own child support obligation. By virtue of recent Illinois
law, a 2503(c) Minor's Trust can be set up with funds held by a custodian under
the Uniform Transfers to Minors Act.
An Irrevocable Life Insurance
Trust is a trust that holds life insurance with a death benefit payable on the
death of a named individual (usually the donor of the trust). This planning
vehicle combines the standard life insurance feature of no-tax on income and
appreciation with the benefit of no-estate-tax on payment of death benefits. To
achieve the latter feature the trust holding the life insurance must be
irrevocable, it cannot be under the control of the donor, and the donor cannot
have any incidents of ownership in the policy within three years of his
death.
The donor typically funds
the premium payments paid by the trust with annual exclusion gifts made to the
trust. To satisfy the present interest requirement of an annual exclusion gift
the trust must provide that beneficiaries have the right to withdraw gifts to
the trust for a specified period of time (usually 30 days). The trust language
provides that if the gift proceeds are not so withdrawn the power to withdraw
lapses. This present interest feature is the basis of a Crummey Power Trust.
After the power to withdraw lapses the funds can be used by the trustee to pay
premiums.
A donor can currently give
$1,000,000 free of transfer taxes. It doesn't matter whether the transfers are
made during the donor's life or at his death. The $1,000,000 exemption is commonly
referred to as the "unified credit", the "applicable exclusion amount" or the
"credit shelter amount".
An
additional exemption is the annual gift tax exclusion. $10,000 ($20,000 for
married persons) can be given to each donee per year without being charged
against the donor's lifetime unified credit. No reporting of such gifts is
required. Unlimited transfer tax free gifts may also be made in the form of
direct payments to health care providers and schools, the latter for tuition and
fees.
If you are likely to incur
estate taxes at death it may be advisable to give away more than the annual gift
tax exclusion amount (thus using up part of your unified credit). This would
exclude subsequent appreciation of the gift property from your
estate.
Even if a donor uses up
his unified credit during his life it may be advantageous to continue gifting
over and above the annual gift tax exclusion amount. This is because payment of
gift taxes earlier than three years before the donor's death removes the amount
of the tax paid from his taxable estate. This benefit is apparent from the
following example:
A lifetime gift
of $1 million in the 50% tax bracket would generate a gift tax of $500,000, so
the gift and the tax would total $1,500,000, of which the recipients end up with
$1,000,000 or 66.6%, making the net transfer tax rate 33.3%. A death-time
transfer of $1,500,000 at the 50% rate results in an estate tax of $750,000,
leaving $750,000 for the beneficiaries. The effective net transfer tax rate in
the latter example would be 50%.
In both examples, the combination of the transfer and the tax totals
$1,500,000, but the lifetime gift results in the beneficiaries receiving $250,000 more.
Keep in mind that the donor must outlive the gift by three years. Otherwise, the
gift tax paid is brought back into the estate and included in its value for
estate tax purposes, with the donor getting credit for the gift tax
paid.
Annual exclusion gifts can
be made in trust to provide advantages for beneficiaries. These may include
protection from trade and judgment creditors, transfer tax exposure reduction,
avoidance of waste, fund management, and funding for multiple generation special
needs and incentives. For more on this, see the Crummey Power Trust discussion
above.
AEPAD is the American Estate Planning Attorney Directory. While the information on this site deals with legal issues, it does not constitute legal advice. If you have specific questions related to information available on this site, you are strongly encouraged to consult an attorney who can investigate the circumstances of your situation and the particulars in your state.