A Credit Shelter Trust is an Estate Planning tool used by married couples specifically for the purpose of reducing estate taxes (or “death taxes”) due upon the death of the second spouse. The Credit Shelter Trust operates much the same way as a Disclaimer Trust by using the federal and state exemption amounts of the first spouse in the amount of the gifts to the Credit Shelter Trust while giving the surviving spouse access to those assets as necessary to maintain their standard of living.
The estate tax in Washington state is applied on the amount of the estate over $2 million (the $2 million is called the “exemption amount”). While the amounts given to a surviving spouse are completely exempt from estate tax at the time of the first spouse’s death, the full estate is taxable upon the death of the second spouse (thus tax is not eliminated, but instead delayed until the death of the second spouse). The Credit Shelter Trust allows the first spouse to use up to their $2 million Washington state exemption amount because the money that goes to the trust is not considered a gift to the surviving spouse, as long as certain requirements regarding the way the trust is set up are met, and instead considered a gift to the ultimate beneficiaries of the trust (generally the children, but can be anyone other than the surviving spouse). The surviving spouse still gets the income and principal as necessary from the trust and upon her death, the Credit Shelter Trust assets are then distributed to the residual beneficiaries and, importantly, since they are not part of her estate they are not subject to any state or federal estate taxes.
As mentioned previously, a Credit Shelter Trust operates upon the same principle as a Disclaimer Trust and while a main advantage of a Disclaimer Trust is the flexibility of the surviving spouse to disclaim as much as is necessary and appropriate, the main advantage of a Credit Shelter Trust is the fact that no decisions by the surviving spouse are necessary to ensure that the tax savings are realized. Since tax laws at both the federal and state level always seem to be changing, the language of a Credit Shelter Trust (which is found within the Will itself) should be carefully drafted to allow for any such changes.
Here is an example of how a Credit Shelter Trust can be used to reduce taxes for a moderately wealthy couple. (For more examples see my Washington State Estate Planning Examples.)
- Married couple who are Washington residents have combined assets of $4 million (assume all community property), comprised of the following:
- Cash, securities, bank accounts $700,000
- House $1,000,000
- Retirement accounts $1,000,000
- Life insurance $1,000,000
- Misc. other personal assets $300,000
- Husband and Wife both make Wills which include Credit Shelter Trusts which specify that the full Washington exemption amount will fund the trust upon the death of the first of them. The Credit Shelter Trusts name the surviving spouse as the income beneficiary to receive the income (and principal as necessary for health, maintenance, education and support) of the trust assets while they are alive with the remainder of the trust assets to pass to their children (which could be either in trust or directly, depending on the circumstances and what the couple find is most desirable) upon the death of the surviving spouse.
- At the death of the first spouse, their estate is worth $2 million (1/2 of the community property and all of their separate property). All of the $2 million (the full Washington exemption amount) goes into the Credit Shelter Trust and no taxes (state or federal) are due. If their estate was worth more than $2 million, the remainder not going into the trust would go to the surviving spouse and thus exempt from all taxes as well, so no taxes are due upon the death of the first spouse.
- At the death of the surviving spouse, their estate is worth $2 million (if they have been living off the income generated from their assets and the Credit Shelter Trust assets) and pass to the beneficiaries listed in their will without any taxes due since equal to the Washington exemption amount (and less than the federal exemption amount). The Credit Shelter Trust is not included in the estate of the surviving spouse and thus not subject to any federal or state estate taxes. The trust assets are then distributed according to the terms of the trust.
- At current rates, by utilizing appropriate tax planning and establishing a Credit Shelter Trust, the couple have avoided Washington state taxes of $240,000 which otherwise would be due at the death of the surviving spouse if no tax planning had been included in their estate plans.
While all trust and tax planning increases the cost of estate planning and requires the use of an attorney, that cost is minimal compared to the taxes that could potentially be saved. In the example above, the couple saved $240,000 by engaging an attorney to properly assess their situation and draft appropriate Wills that included Credit Shelter Trusts (a process that typically would cost $1,500 to $3,000). While the administration of a trust also has costs, such as requiring a trustee to keep trust accounts accurate and file tax returns, that cost is also insignificant compared to the tax savings gained through use of a trust.
Although changes to federal law in 2010 introduce a concept called “exemption portability”, this doesn’t really affect the need to use Credit Shelter Trusts as a planning tool. Here is a great, short article by Thomas J. Bouman on the “portability exemption” and Credit Shelter Trusts.