You may have heard credit shelter trusts called by their other monikers: bypass, family or exemption trusts. Assets placed in a CST are generally held apart from the estate of the surviving spouse — they pass tax-free to the remaining beneficiaries at the death of the surviving spouse. But the CST can benefit the surviving spouse in his or her lifetime as well.
Because transfers to surviving spouses are generally free of federal estate tax, CSTs can be used in conjunction with the unlimited marital deduction. At the death of one spouse, if the executor or trustee is directed to fully fund the CST, assets with a value equal to the deceased spouse’s available lifetime federal gift and estate tax applicable exclusion would be transferred to a CST for the benefit of the surviving spouse.
When the surviving spouse dies, the trust assets pass tax-free to the CST beneficiaries. The CST shelters the assets and any appreciation in the value of the assets from inclusion in the surviving spouse’s estate.
The Internal Revenue Code provides for the transfer of the first-to-die spouse’s unused applicable exclusion amount to the surviving spouse, who can then use it for gift or estate tax purposes if he or she elects to do so. Although relying on portability may be easier than creating and administering a CST, a CST has several advantages over electing portability.
- All appreciation in the value of assets in the CST bypasses the surviving spouse’s estate and will not be subject to federal or state estate taxes at the surviving spouse’s death.
- Portability is generally not permitted for state estate tax exclusions (for states that levy an estate tax) and the federal generation-skipping transfer tax exclusion. Therefore, without the use of a CST, any unused state estate tax exclusion and generation-skipping transfer tax exclusion of the first spouse to die will be lost.
- Assets contained in a trust are generally protected from the beneficiary’s creditors.
- The first spouse to die can control where the assets remaining in the trust are distributed after the surviving spouse’s death rather than relying on the surviving spouse to carry out the wishes of the first spouse to die.
When consulting with your attorney or tax adviser, consider these possible downsides to a CST:
- Income tax returns must be filed for the trust to obtain the benefits of a CST. If the assets that are used to fund the trust are complicated, this filing can be cumbersome and expensive.
- The tax basis of the assets in a CST is stepped up only once — at the death of the first spouse — unlike with portability, in which the tax basis would be stepped up a second time upon the death of the second spouse.
- The surviving spouse must be willing to accept only certain rights and limited control over the assets in the trust. He or she can usually access all the trust’s income, and as the trustee can draw on the principal to pay for health, education, maintenance, and living expenses.
The CST ensures a legally married couple passes both their estate tax exemptions to their heirs in their entirety. It’s a revocable trust and won’t offer any additional tax advantages beyond ensuring two full exemptions. But the state and federal estate tax exemptions are a major benefit to consider.
If the estate is worth more than the applicable threshold in one’s state — if your state has an estate or inheritance tax in the first place — when the surviving spouse dies, any part of the estate over that threshold will be subject to estate tax.
Without proper planning, the exemption of the first spouse to die is lost. The way to preserve both spouses’ exemptions is the CST. Because state estate or inheritance tax thresholds are usually far lower than that of the federal one, the surviving spouse may end up with an estate over the state’s threshold and be subject to a substantial state tax.
Consider speaking with your attorney to further understand the ins and outs of your situation.