This series began as a discussion of wills, intestate distributions, types of trusts, and then moved onto Disclaimer Trusts. In summary, the trusts we have touched on all take the form of a Credit Shelter Trust. The Disclaimer Trust is unique. Rather than being funded “mandatorily” at the death of the first spouse, the surviving spouse has nine months to decide if the trust has value “at that time.” In other words, its future funding is optional and left in the hands of the surviving spouse based upon circumstances as they exist at the death of the first spouse.
Important note of distinction:
Anyone who is left money may “disclaim,” but only a spouse can disclaim and still be the beneficiary of the disclaimed assets.
So, let’s begin with the advantages of a Credit Shelter Trust and its uses:
- Creditor protections.
- Assets are guaranteed to go to named beneficiaries if anything is left at the death of the primary beneficiary.
- It’s an incredible income tax planning tool for the survivors named as beneficiaries when “sprinkling” provisions are available.
- Eliminates the need for a court appointed “Conservator” or Guardianship.
- In some cases, there are estate tax savings at both the Federal and State levels.
- Future appreciation is not taxed in the estate of the surviving spouse (This is a double-edged sword).
- Potential limitation on the jurisdiction of the Probate Court.
Creditor Protections
The assets in the Credit Shelter Trust are owned by the trust and not the surviving spouse. Assuming careful drafting, the assets are shielded from creditor claims while held in the trust. Bankruptcy courts, divorcing spouses, and general creditors cannot get at these assets.
As a financial advisor, we’ll always recommend that property and casualty insurance be obtained to cover the spouse’s vehicle(s) and home(s), and we’ll add an umbrella policy to back up all of the underlying policies. Our recommended policy is a minimum of $2,000,000 for an umbrella policy, but never less than total net worth.
An example:
Our surviving spouse is driving home one night, stone sober. They fall asleep at the wheel and kill two people. There will be a lawsuit and the spouse’s personal assets are first backed up by the auto policy up to the limits of their liability coverage—let’s assume $500,000. If the claim exceeds that amount, the umbrella (let’s assume $2,000,000 of coverage) is next to cover losses to its limits. This is assuming there is an “umbrella” policy. This provides a combined coverage of $2,500,000. What if this is not enough? The personal assets are next to go. If the lawyers or creditors then try to reach for the assets in the Credit Shelter Trust, they should be out of luck with proper drafting.
In summary, the assets of the Credit Shelter Trust left for the lifetime of the surviving spouse’s benefit and possibly their children will not be accessible to these claims and may be the only assets left for the family to depend upon.
Guaranteed to Go to Named Beneficiaries
When assets are left outright to a surviving spouse, their future distribution is in the hands of the owner, in this case, the surviving spouse. Under normal circumstances, this would be just fine as your children would be the primary beneficiaries, especially in a first marriage. And on this subject, what legal rights does the second spouse have in this case to the first partner’s assets?
Suppose one partner dies first at a young age leaving the surviving spouse and young children. How likely is it that the surviving spouse may remarry? If they do remarry, how then are the children protected from assets passing to the second spouse?
The Credit Shelter Trust provides a virtual guarantee that a portion of the deceased spouse’s assets will remain in trust and at the death of the surviving spouse, the remaining assets go to their children. We may do this by placing some restrictions on the ability to distribute principal of the trust to the surviving spouse, especially if they remarry.
It may not be obvious, but the language of the trust will be critical in not only managing the assets, but will determine the level of access the surviving spouse and or the trustees may have in providing for the wellbeing of the spouse and in many cases, their children through the use of “sprinkling” provisions.
Income Tax Planning Tool for Survivors Named as Beneficiaries
Examples of language to be used: This is not intended to be legal advice as only a qualified estate planning attorney can offer legal advice.
Traditional Language for Surviving Spouse:
“All of the income from the trust ‘shall be’ distributed to my spouse at least quarterly”. This language leaves no options. The trustee is “required” to distribute all of the income at least quarterly. As a young trust officer years ago, this was the language used most often. This type of Credit Shelter Trust is known as a “Simple” trust: One that requires that all income be paid out to the beneficiary at least annually.
Optional Language We May Use Today:
“The income ‘may be’ paid to a class of beneficiaries consisting of my spouse and/or our lineal descendants in equal or unequal proportions as the trustees may determine in their absolute discretion. However, the needs and desires of my spouse shall always come first and foremost. Any income that is not paid out each year shall be added to principal at least annually.” (This is a guidance clause for the direction of the trustees). This type of Credit Shelter Trust is known as a “Complex” trust as it allows for the accumulation of income rather than required distributions.
Note the options presented to the trustee(s):
- If the spouse needs all of the income, he/she/they can get it. (Guidance Clause)
- If a court or creditors asserts claims against the spouse, the trustee can hold back income distributions until a resolution can be reached.
- If instead, there is a reason to pay the income directly to a child, the trustee has the power to do so. (Familiarize yourself with what is known as the “Kiddie Tax” when trust income is paid to a child). The surviving spouse can act as sole trustee. However, if they want to get income (sprinkle) to any other permissible beneficiary other than themself, they will need the power to name an “independent” co-trustee to do this properly.
- A very similar clause can be used for the distribution of the Trust’s principal to or for the benefit of the spouse and/or Lineal Dependents.
Avoid the Need for a Court Appointed Conservator
Although this will be applicable to both a Testamentary Trust and/or a Living Trust, by appointing your named trustees to act on behalf of the beneficiary, there would be no need for a court appointed conservator or for a guardianship appointment as this has been taken care of through the use of these documents.
Future Appreciation of Credit Shelter Trust Assets are not Taxable in the Estate of the Second Spouse to Die
This can best be explained as follows. When assets coming from the first spouse to die are transferred into the Credit Shelter Trust, they are not the property of and are not owned by the surviving spouse. What you are doing is giving the spouse “life use” of these assets rather than outright ownership. In this manner, at the death of the second spouse, the assets pass on to the named beneficiaries at the Credit Shelter Trust cost basis, either carried over from the date of death of the first spouse or for those assets that have been bought during the lifetime of the surviving spouse and owned by the Credit Shelter Trust, at their cost basis to the trust.
Estate Tax Savings
Although our clients see Estate Tax Savings as a major advantage of the use of a Credit Shelter Trust, we don’t necessarily place a lot of weight on this particular issue due to the size of the federal exemption and the ability to use such a trust when state estate taxes are an issue.
For those families with total assets of less than $12.06 million in 2022, you may remember that there will be no federal tax. We then look to the state and to the extent a “state” estate or inheritance tax may be applicable, we try to fund the Credit Shelter Trust up to a maximum of the state exemption to avoid some or all of the state/estate tax at the death of the second spouse. This is not very difficult; however, it does need careful drafting by a competent estate planning attorney.
For those “married” couples with combined assets of $24.120 million, our recommendation would be to fully fund the Credit Shelter Trust at the death of the first spouse up to a maximum of $12.06 million with language that will increase this amount due to the permanent nature of the cost-of-living increases that have been passed by Congress. In this manner, the assets of the Credit Shelter Trust will be exempt from federal estate taxes at the death of the second spouse and with a second full exemption for the surviving spouse, no federal estate taxes should be due if properly planned, at least at the federal level.
Jurisdiction of the Probate Court
As you may remember from prior discussions, the use of the Living Trust has the advantage of eliminating the need for probate court jurisdiction for the lifetime of the trust. This is not true when a Testamentary Trust is used as the trust remains under the jurisdiction of the court until the trust is terminated.
The takeaway here should be the value of using a Credit Shelter Trust as a tool in our planning. Does it play into every estate plan? Of course not. Should it be a consideration? Absolutely. As planners, we need to understand when and where it “may be” appropriate.