Using a “Credit Shelter” or a “Bypass” Trust in Your Will: a Good Thing or a Terrible (Tax) mistake? (and Why You Should Review Your Existing Will!)

Written by: Wills, Trusts, & Estate Administration

Unfortunately, there is far from a one-size-fits-all answer.

My October blog explored the use (or risks) of these trusts in older Wills as related to the possibility of inadvertently disinheriting a spouse. This article will explore their use from an overall federal estate tax, and capital gains tax, perspective.

First a little history. A person’s federal estate tax exemption amount (previously known as the “unified credit”) is the amount of assets that may pass to someone other than the spouse without incurring estate taxes. For many years, particularly throughout the 1980s, 1990s, and even well into the 2000s, a decedent’s exemption amount was regularly utilized to create a trust at the death of the first spouse, commonly known as a “credit shelter trust” or “bypass trust”. As explored in October’s blog, the purpose of this trust was to take the maximum amount of assets that a decedent could pass to someone other than his or her spouse without incurring estate taxes and hold it in trust. The creation of this trust resulted in the exclusion of the initial funding amount, as well as the growth thereon, from federal estate tax in the estate of both the first and the second spouse to die.

The downside to these trusts is that since the assets (and their growth) were not included in the taxable estate of the second spouse to die, the assets, when eventually paid out (usually to the children) did not receive a further step up in basis at the death of the second spouse, such that the children inherited the assets with built in appreciation that had accrued since the date of the first spouse’s death, such that a capital gain tax would be incurred upon a subsequent sale.

There have been very significant changes in the exemption amount (increasing from $600,000 as recently as 1997, to currently being $5,450,000 in 2016). In addition, we now have “portability”, such that if the first spouse to die does not utilize his or her exemption amount, it can carry over to the surviving spouse (giving the surviving spouse $10,900,000, rather than $5,450,000, which can be sheltered from tax).

There are still many situations where credit shelter trusts are appropriate, or even necessary for estate tax planning purposes, to be used in a Will. These include, but are not limited to, situations where there is a second marriage and there are children from a prior marriage, or where a husband and wife’s assets are anticipated to exceed (by the time of death of the second spouse) the exemption amount, or for creditor protection planning.

However, what about a moderate sized estate? Is a credit shelter trust appropriate? Let’s assume Husband & Wife, on their first marriage and with 3 children, have a net worth of $2,000,000 or $4,000,000 or $6,000,000. Is there a reason to use a credit shelter trust? Well, there may be, but if so it is NOT estate tax planning. In these type situations, we are often better to either leave all the assets outright to the spouse, or alternatively, leave them in a marital QTIP trust for the surviving spouse. In this fashion, the assets in the QTIP trust (including the growth up until the second spouse’s death), will be included in the gross estate of the second spouse to die. These assets will then receive a second step up in basis at the second spouse’s death, wiping out any potential for capital gain taxes. So long as the surviving spouse’s individual assets and assets in the trust do not exceed $10,900,000 (as indexed for inflation), there will be no estate tax due. Thus, we’ve avoided estate tax, and eliminated capital gain tax.

There are countless individuals who still have Wills that were drafted in the 1990s and early 2000s, back when the credit ranged between $600,000 and $2,000,000. For those who have Wills that are more than 5 years old and contain a credit shelter trust, it is imperative to review these Wills to determine if the use of the credit shelter trust will result in a terrible tax result that could otherwise be avoided.