Each person can pass to heirs a certain amount of property free from federal estate tax. For 2008, the tax-free amount is $2 million; for 2009, it’s $3.5 million. This tax-free amount is the portion of the estate shielded by a unified credit claimed by the estate against the federal estate tax that would otherwise be due.
A married person can leave an unlimited amount to his/her spouse; there is an unlimited marital deduction. But in order for couples with sizable estates to each use their credit amount and not waste any of it, couples use a tried-and-true strategy called the credit shelter trust.
The credit shelter trust, also referred to as a bypass trust (because it helps to bypass one of the spouses’ estates), is a way for couples to have their cake and eat it, too. They can ensure that the surviving spouse enjoys the couple’s full property, while minimizing estate taxes for the surviving spouse’s estate.
Here’s how it works: Each spouse sets up a credit shelter trust under the terms of his/her will (it can also be created through a living trust). The trust comes into effect when the first spouse dies and provides that the surviving spouse has an income interest in the trust for the rest of his/her life. This means the surviving spouse can enjoy all of the earnings from the trust and even use property from the trust (“trust principal”) when needed for certain specified circumstances. On the surviving spouse’s death, the funds remaining in the trust pass to the trust’s remainderman, typically the couple’s child.
Because the surviving spouse does not own the property in the trust (he/she has only an income interest that expires when he/she dies), there is no property interest to include in the surviving spouse’s estate. The surviving spouse has the benefit of the property from the first spouse without the estate taxes that would otherwise be due on it.
To grasp the powerful impact on tax savings by using a credit shelter trust, compare what happens to a couple’s combined estates when they do, or do not, use such a trust.
Without a credit shelter trust. Say each spouse owns $3 million and each leaves all assets to the survivor outright. If the husband dies in 2007, there’s no federal estate tax on his property because all of it is shielded by the unlimited marital deduction. If the wife dies in 2008, her estate is $6 million (her $3 million, plus the $3 million inherited from the husband). After applying her $3.5 million exemption amount, this leaves $2.5 million taxed at 45%, or an estate tax of $1,225,000 (ignoring any other deductions and credits for purposes of the example).
With a credit shelter trust. Same as above, except that when the husband died, $2 million went into a credit shelter trust, of which the wife was the income beneficiary. Again, there is no federal estate tax on the husband’s death ($2 million of his estate is shielded by the unified credit amount and $1 million by the marital deduction). If the wife dies in 2008, her estate is only $4 million (her $3 million, plus the $1 million that passed outright to her from her husband). After her exemption amount of $3.5 million, only $500,000 of her property is taxable. The tax is $225,000. The tax savings from using the credit shelter trust: $1 million!
It is not uncommon for couples to want a credit shelter trust and even go so far as to create one under the terms of their will, only to find out that the trust cannot accomplish the desired estate tax savings. The reason: There may not be sufficient assets to fund the trust, which can waste part of the credit amount in the estate of the first spouse to die and cause additional taxes in the surviving spouse’s estate.
In order to have assets that can go into the trust to fulfill the requirements of the trust terms, it is important for each spouse to have sufficient assets in his/her name. Jointly held assets cannot be used to fund a credit shelter trust; they pass automatically to the surviving joint owner. If spouses want to use a credit shelter trust and do not own assets independently, they can consider severing ownership of jointly held assets. This option should be discussed with a knowledgeable attorney.
Tax-related identity theft continues to be a problem for individuals. The Taxpayer Advocate Service saw a 157% increase in such cases from March 2011 to March 2013.
Source: National Taxpayer Advocate Semi-Annual Report, 6/30/13View all factoids