A credit shelter trust is a simple but highly effective approach to ensure that each spouse’s full estate tax exemption amount is utilized. This article is all about showing you the pros and cons of credit shelter trust, including its advantages and disadvantages. A diagram has also been given to illustrate how credit shelter trust works, especially in New York City. Read on!
What is Credit Shelter Trust?
A credit shelter trust (CST) is a trust established after the death of a married couple’s first spouse. Assets placed in the trust are normally kept separate from the surviving spouse’s inheritance. Thus, allowing them to pass tax-free to the remaining beneficiaries upon the surviving spouse’s death. The assets retained in the CST can benefit the surviving spouse for the rest of their lives. We sometimes call credit shelter trusts bypass trusts, family trusts, or exemption trusts.
The surviving spouse retains certain rights to the trust assets for the rest of their life, which is a significant advantage of this sort of trust. Under certain conditions, such as the need to support certain medical or educational needs, the surviving spouse can access the trust’s principal rather than merely the income. When the surviving spouse dies, the remaining beneficiaries receive the assets of the trust without having to pay estate taxes.
What is it’s purpose?
Wealthy married couples employ CSTs to safeguard their estate from taxation when the first spouse dies. It’s a strategic approach because the Trust only becomes relevant when the first spouse dies. CSTs might comprise a portion or the entirety of an estate. The ultimate goal of a CST is to create a tax-efficient means to keep assets in a Trust for the benefit of a surviving spouse.
One caveat: if your purpose is to avoid taxation, a CST must have a designated Trustee other than the surviving spouse. It is important to note that the surviving spouse never has actual authority over the assets. However, if specified in the Trust, there are exceptions to this restriction (such as funds allowed for educational expenses or medical bills).
How does it work?
The provisions for establishing a credit shelter trust must be included in your and your spouse’s wills or revocable living trusts. However, the credit shelter trust does not become active until one of the spouses dies. At that point, the executor or trustee is directed by the will or living trust to set aside in trust an amount equal to the deceased spouse’s applicable exclusion.
The surviving spouse is entitled to the entire income from the credit shelter trust. He or she may also have access to the principal, subject to the rules you establish. The primary goal of a trust is usually to ensure the financial security of the surviving spouse. (Distributions to others are also permissible if desired.) When the surviving spouse dies, any leftover principle can be transferred to children or held in trust for their benefit, depending on your wishes.
Despite the fact that the surviving spouse has access to the income (and principle, if necessary), the assets in the credit shelter trust are not included in the survivor’s taxable estate. This is significant because, if the credit shelter trust continues to grow, its whole value — both the original value and any increase — is exempt from estate taxes upon the death of the second spouse.
How do we implement it?
Your attorney can draft your will or living trust to contain the necessary requirements and create your trust in the most appropriate manner for your family situation and personal goals.
If you live in a state with its own estate tax, you may need to arrange ahead of time. The available state exclusion is lower in a number of states than the federal exclusion. Your attorney can assist you in developing a strategy that accounts for the variances between the federal and state exclusion amounts.
Once you’ve made the required arrangements in your will or trust, it’s critical to make sure that enough assets fall under your will or trust. Talk to your attorney about how to organize asset ownership, title accounts, and beneficiary designations when writing your will or trust. Your financial advisor can assist you in putting your attorney’s recommendations into action.
Credit Shelter Trust Diagram
The diagram below depicts the credit shelter trust scheme
Credit Shelter Trust Pros and Cons
Like every other venture, credit shelter trust has its own pros and cons:
- The surviving spouse can use the assets of the deceased spouse without increasing their tax base.
- The assets of the departed spouse will be shielded against creditors, new spouses, and sources of depletion.
- When the second spouse dies, the heirs are exempt from paying an estate tax.
- The surviving spouse has only limited access to and management over the trust funds.
- Setting up a CST might be costly.
Advantages and Disadvantages of Credit Shelter Trust
The advantages of establishing a credit shelter trust include:
#1. Asset safeguarding
A CST shields a surviving spouse’s assets from creditors, children, or a new significant other. In this way, the parties cannot use the assets irresponsibly, not even to pay their own bills.
#2. Inheritance safeguards
If the current family is made up of children from past marriages, each spouse can ensure that their piece of the estate goes to their selected beneficiaries – for example, children from a prior marriage – as well as the beneficiaries of a surviving spouse.
The trust can be written to give the surviving spouse limited power of appointment. For example, the surviving spouse may be entitled to transfer assets to a new special needs trust to pay for a kid who developed a need for additional care after the trust’s creator died.
#4. Extend the Generation-Skipping Tax (GST) Exemption as much as possible
The GST exemption is not transferable. However, a bypass trust can direct the GST to a GST-exempt bypass trust, preserving the exemption for minors.
#5. Defending against taxation on asset increase
After the first spouse’s death, an asset portfolio of stocks and property in a CST can grow in value and yet pass estate tax-free to the bypass trust beneficiaries.
#6. Benefits from property taxes
A CST distribution to a child is treated as a transfer from the decedent spouse rather than the surviving spouse. As a result, this distribution may be eligible for the decedent spouse’s parent-child property tax reassessment exclusion.
Disadvantages of Credit Shelter Trust
Credit shelter trust, however, has its own disadvantages:
- For the CST, income tax returns must be filed. Because the assets used to fund the trust might be complicated, submitting returns can be onerous and costly.
- The tax basis of assets in a CST is only moved up once, at the death of the first spouse. When the second spouse dies, the tax basis is stepped up again under portability.
- The surviving spouse must be willing to relinquish some of his or her rights and control over the assets. They have general access to all of the trust’s income. If they are the trustee, they can use the principal to pay for health, education, and other expenses. If someone other than the spouse is chosen as trustee, the surviving spouse may be entitled to use some of the trust funds for other purposes at the trustee’s discretion.
How do you establish a credit shelter trust in New York? Read on.
Credit shelter trust vs Marital trust
It is important to understand the difference between a credit shelter trust and a marital trust. A marital trust is a kind of credit shelter trust. You and your spouse can use a marital trust to leave assets to a surviving spouse, children, or grandchildren. When the person mentioned in a marital trust dies, the assets pass to the trust, and the surviving spouse can use the income generated by the trust but not the principal. In a credit shelter trust, however, the surviving spouse can use both the income generated by the trust and the capital.
Marital Trusts include a Power of Appointment, QTIPs, and Estate Trusts. Before deciding which of these estate planning tools to include in your Will, it is critical to understand each of them and how they can benefit you and your family.
Credit Shelter Trust New York
New York has an estate tax in addition to the federal estate tax, and the estate tax exemption amount of one spouse is not transferrable to the other. The current estate tax exemption level in New York State is $5.93 million. This implies that if a spouse dies without adequate planning, they can leave everything to their spouse tax-free. This is due to the unlimited marital deduction. However, the estate tax will be required on the whole amount of their estate and the estate of the spouse when the second spouse dies. There is a further penalty for failing to plan. If the estate of the second spouse exceeds the New York State estate tax exemption amount, they will be taxed not just on the excess amount, but on the entire estate at a rate ranging from 5% to 16%.
A credit shelter trust ensures that each spouse’s full estate tax exemption amount is utilized. The trustee of the credit shelter trust will pay any income generated by the trust to the surviving spouse. The trustee may also spend the trust principal for the benefit of the surviving spouse. This is subject to certain conditions that should be negotiated with your estate planning counsel.
A credit shelter trust should be tailored to your family’s specific needs. It should never be tried without the assistance of an estate planning expert in your area. You can call 347-766-2685 to speak with an experienced estate planning attorney about whether a credit shelter trust is right for you. That is of course, after weighing the pros and cons of a credit shelter trust.
Frequently Asked Questions
Is a credit shelter trust irrevocable?
You can amend the provisions of the trust at any moment throughout your life since it is revocable. When you die, it becomes an irrevocable trust, and assets – usually the remainder of your estate tax exemption – are transferred to the trust.
How is income from a credit shelter trust taxed?
Because assets given to a surviving spouse are excluded from federal estate taxes, a credit shelter trust serves as a tax management tool. There is no cap on this amount. Normally, after the death of the second spouse, taxes are paid on any assets from that spouse’s estate that is passed on to beneficiaries.
What happens to a credit shelter trust when the surviving spouse dies?
When the surviving spouse dies, the residual assets are dispersed in accordance with the conditions of the trust. The assets under the credit shelter trust, including any gain in value during the surviving spouse’s lifetime, pass to the heirs, free of the estate tax.