I tell almost all of my clients who are married and have an estate worth more than $1,000,000 to consider using revocable trusts in their estate plan to defer payment of estate tax for as long as possible. This type of trust, often called a Credit Shelter Trust, used in conjunction with a pour-over will, can be the cornerstone of a couple’s estate planning. It should be utilized before considering more complicated trusts, such as Irrevocable Life Insurance Trusts or Qualified Personal Residence Trusts, where tax planning is involved.
How does the Credit Shelter Trust work? A little tax background is necessary.
The federal estate tax is imposed on the value of a decedent’s estate, reduced by various deductions. The tax is computed using a unified rate schedule, taking into account lifetime taxable gifts and the transfers being made at death. The lifetime exclusion amount for gifts and estates (formerly known as the unified credit) is $5,340,000 for 2014. This amount is indexed to inflation and likely will increase annually. The federal estate tax rate is currently 40% of the value of the taxable estate that exceeds the exclusion amount.
The taxable estate is determined by deducting from the gross estate certain items, including debts of the decedent, funeral expenses, expenses of administering the estate, state estate taxes, transfer to charities, and qualified transfers to the surviving spouse (called the marital deduction).
It is the marital deduction that provides the ability to use trusts to eliminate estate tax on the first death and to defer all estate tax until the death of the surviving spouse. The marital deduction is “unlimited,” meaning that any asset that passes to a surviving spouse is estate tax free, provided that it meets the requirements of Section 2056 of the Internal Revenue Code.
Because the federal estate tax exclusion amount is now so high ($5,340,000) and because we now have “portability” on the federal level (portability allows the surviving spouse to “inherit” the unused portion of the deceased spouse’s exclusion amount), the federal estate tax is usually not a consideration in estates worth less than $10,680,000.
However, for those of us who reside in Massachusetts, there is a Massachusetts estate tax on any estate larger than $1,000,000 in value. Many estates will exceed that amount, so estate tax planning is still alive and well in Massachusetts.
A common Massachusetts estate plan first makes use of the deceased spouse’s unified credit (the exclusion amount of $1,000,000), and then uses the unlimited marital deduction to defer any remaining estate tax until the surviving spouse’s death. This is the crux of tax planning with Revocable Trusts.
Under the Credit Shelter Trust, the amount that is sheltered (up to $1,000,000) is placed in a “Family Trust” for the benefit of the surviving spouse and other beneficiaries such as children, grandchildren and others, or it can be for the benefit of the spouse alone. The amount in the Trust in excess of $1,000,000 goes into a “Marital Trust” for the sole benefit of the surviving spouse.
When the surviving spouse dies, only the remaining assets in the Marital Trust will be taxable in the surviving spouse’s estate, effectively saving any estate tax on the first $1,000,000 of assets.
To implement this tax plan, the Revocable Trust is set up to provide as much flexibility to you and your spouse as possible, but to still ensure that the Family Trust will avoid estate tax in both estates. I will summarize the provisions commonly included in the Revocable Trusts and point out options to customize the trust for you and your family in my next post.