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May 3, 2016
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By J. Corey Reeder

When the President signed the American Taxpayer Relief Act of 2012, some observers thought that certain provisions would sound the death knell for a popular legal tax shelter strategy known as Credit Shelter Trusts (CST).

Although the need for CSTs may have been reduced, this kind of trust is still a valuable tool to consider in an estate plan that you and your attorney, accountant or estate planner should consider.

Prior to passage of the Taxpayer Relief Act, the first $5.12 million in assets of a decedent’s estate was exempt from Federal estate tax. However, in the case of a married couple with a sizable estate, both spouses could establish a CST, effectively doubling their exemption amount. This strategy allowed up to $10.24 million to pass to beneficiaries tax-free after both partners passed away.

Consider the following example of a husband and wife with two children.  Husband had assets totaling $6 million and his wife had assets of $3 million, thus their combined estate would be worth $9 million.

Upon the death of husband, assets totaling the amount of the exemption (i.e. $5.12 million) would be held in a CST for use by his wife during her lifetime with the remaining assets of the husband (i.e. $880,000) passing directly to his wife free of trust.  When the wife passes away, money in the CST would pass tax free to the children.  In addition, the wife’s entire estate of now $3.88 million would pass directly to the children tax free given the amount of her estate is below the exemption amount. 

The failure to utilize a CST in this situation would result in wife receiving $6 million dollars outright upon the death of her husband thus increasing the size of her estate to $9 million. Upon her death the entire $9 million would pass to the two children, however, $3.88 million would be subject to federal estate tax because her husband’s exemption has been lost.

The Taxpayer Relief Act made the federal estate exemption “portable” for both spouses, which means that a surviving spouse could utilize any unused portion of the deceased spouse’s exemption simply by filing the appropriate tax return without the need to use a CST as outlined in the above example.

While “portability” may have minimized the need for many couples to establish a CST, a number of circumstances still make it smart to consider creating one, such as the following:

1. When one or both spouses have children from a previous marriage

Under the “Brady Bunch” scenario in which one or both spouses have children from a previous marriage, the surviving spouse would typically stand to inherit all of the partner’s assets in the event of his or her death. Establishing a CST ensures that if one partner passes away, the surviving spouse will still be able to use certain assets subject to the terms of the CST with the bulk of his or her assets being preserved for the children of their previous marriage.

2. When a couple has children and one spouse dies and remarries

Under this scenario, the couple has children and one spouse passes away.  Creating a CST ensures the surviving spouse would be provided for during his/her lifetime, while at the same time guaranteeing that upon the death of the surviving spouse that the children receive the remaining assets.  Not utilizing a CST in this situation would permit the surviving spouse to pass the assets as he or she saw fit which may include distribution to a new spouse if the surviving spouse chose to remarry.

3. When an inheritance skips a generation

While the federal exemption is portable when passing an estate to a couple’s children, “portability” does not apply when the couple wishes to provide for multiple generations of the family. Setting up a CST is necessary in this case to ensure that both partners’ exemptions can be utilized.

4. Creditor Protection

An additional benefit to a CST is that the assets that are held in trust are protected from the creditors of the surviving spouse which is not the case with “portability”.

5.  Asset Appreciation Protection

Another possible reason to consider utilizing the CST structure is to protect the appreciation of assets from being subject to estate tax as opposed to “portability” which only protects the deceased spouse’s exemption.

While CSTs still retain a certain utility as an estate planning tool, one continued negative of utilizing a CST as opposed to relying on “portability” under the Act relates to the “stepped-up basis”.

For example, husband owns stock with a basis of $10,000 and that asset is worth $100,000 at the time of the husband’s death.  If the husband has a CST, the value of that stock when it becomes part of the CST is $100,000.  When the CST is terminated (i.e. upon the passing of the wife) the stock is worth $140,000 and if sold at that time, the beneficiaries of the CST would pay capital gains tax on the difference between the final sale price of the stocks and the $100,000 stepped-up basis following the husband’s death.

In this case, the heirs would pay tax on $40,000. By relying on “portability” in the same situation, the stock would pass to the wife upon the death of the husband and the basis of the stock would be $100,000 and upon the death of the wife, the stock would be worth $140,000 and the beneficiaries would receive that value as their basis thus saving capital gains tax on $40,000. 

While these examples are simple in nature, hopefully they illustrate the importance of understanding the intricacies of the estate planning process and the need to engage qualified practitioners to assist in said process.

J. Corey Reeder is a member of McNees Wallace & Nurick LLC’s Estate Planning Group and works with individuals, businesses and fiduciaries in the areas of estate planning, business succession planning, business counseling, estate and trust administration and probate litigation. He can be reached at 814-867-8500 or creeder@mcneeslaw.com

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McNees is a full-service law firm based in central Pennsylvania with more than 130 attorneys representing corporations, associations, institutions and individuals. The firm serves clients worldwide from offices in Harrisburg, Lancaster, State College and Scranton, PA; Columbus, OH; and Washington, D.C. McNees is also a member of the ALFA International Global Legal Network. www.mcneeslaw.com | @McNeeslaw | LinkedIn