Starting in 2011, widows and widowers can add their unused estate tax exemption of the spouse who died most recently to their own. This provision, plus an increase in the exemption amount to $5 million per person, enables married couples together to transfer as much as $10 million tax-free to their children or other heirs–either by making lifetime gifts or through an estate plan.
Portability–the ability of a deceased spouse’s credit to be transferred to the surviving spouse–is an extremely positive development that can simplify planning for many people. But for others it raises tough choices about whether to abandon more complex estate planning tools that may have other advantages. To further complicate matters, portability only applies to deaths in 2011 and 2012. So until Congress makes it permanent, there is a risk that it will expire before most folks can take advantage of it. Agents and advisers can expect clients to ask: “Why do I need a credit shelter?”
Basic credit shelter trust. When the first spouse dies, the trust is funded with up to the exemption amount. The trust distributes income and principal to the survivor or other family members (usually the couple’s children) while the surviving spouse is alive, then passes on whatever is left to family. Funds in the trust are covered by the exemption amount and are not taxed when the first spouse dies. Nor are they considered part of the survivor’s estate, so they are not subject to tax when she dies.
Now that portability makes it unnecessary in most cases for spouses to use a credit shelter trust solely to preserve the federal exemption amount, is this planning device defunct: Not by a long shot. Still, it’s never been for everyone, and far fewer people may need it now than in the past. Whether your clients are among them depends on various factors, including their net worth, family relationships, investment outlook and tolerance for complexity. Here are some reasons to use, or not use, a credit shelter trust.
Protect the inheritance from creditors. Preserving resources for your client’s heirs goes beyond sound investment and money management. You also need to guard against the possibility that, sometime in the future, the objects of their bounty could lose assets to their own creditors. They may include everyone from disgruntled spouses and ex-spouses to people who win lawsuits against the family.
Leaving assets to heirs in a family trust, rather than outright, is an excellent means of sheltering family assets from creditors. For many people this is the main reason to set up trusts and to leave assets permanently in this legal wrapper.
Spouse might remarry after client’s death. This raises a couple of additional concerns. One involves children if they don’t get along with the stepmother or stepfather. Picture this: surviving spouse commingles everything with this great-unknown quantity and the kids get completely cut out. Stranger things have happened. With a bypass trust, your client can avoid that result.
Your spouse might strike it rich.Putting the funds in trust, rather than leaving them outright, ensures that neither the assets nor any appreciation on them will be considered part of the spouse’s estate. A credit shelter reduces the possibility that by time the spouse dies his or her net worth will be more than the exemption amount.
Client has grandchildren (or might someday).Portability does not apply to the $5 million exemption from generation-skipping transfer tax. This is the 35% levy that applies, on top of estate or gift tax, to assets given to grandchildren and more remote generations (or to trusts for their benefit). So if you do not want to lose the exemption, you must use it, either by making lifetime gifts or by factoring it into your estate plan. There are various ways to do this. One is to include grandchildren as beneficiaries of a bypass trust and to apply at least part of the client’s exemption to that trust.
Plan already includes a credit shelter. Given the potential benefits this trust affords, carefully have your clients before they revamp their plan and ditch it. But if they haven’t revised their documents in a number of years, do make sure they still reflect your client’s intent about how much money is destined for one of these trusts.
Client wants to avoid administrative pitfalls. There’s a big one lurking with portability: The executor handling the estate of the spouse who dies first needs to transfer the unused exemption to the survivor, who can then use it to make lifetime gifts or pass assets through his or her estate. This must be done by filing an estate tax return when the first spouse dies, even if no tax is due.
This return is due nine months after death with a six-month extension allowed. Spouses ought to file it even if they’re not wealthy today, because someday, who knows? But if the executor doesn’t file the return or misses the deadline, the surviving spouse loses the right to use her late spouse’s remaining exemption.
We don’t trust Congress. Along with all the other estate tax goodies in the new law, portability is set to expire on Dec. 31, 2012. If Congress doesn’t act before then, not only could we lose portability, but the exemption amount will revert to $1 million and the rate will increase to 55% from the current 35%. Look before you leap.