A credit shelter trust is a trust executed by a spouse primarily to save on estate taxes. Because the need to pay state estate taxes in New York in 2021 only applies to gross estates with a value of more than $5.93 million, a credit shelter trust is used by only a few estates. However, the use of a credit shelter trust should be reviewed carefully because assets in a credit shelter trust do not enjoy a stepped-up basis when the surviving spouse dies, and thus, if the assets are later sold, there will be a larger capital gains tax.
The concept of a credit shelter trust
A credit shelter trust is executed by a spouse, usually in his will or during his lifetime but effective upon his death, allocating his assets up to a basic exclusion amount to a credit shelter trust with the remainder given to the surviving spouse under a marital deduction. This system allows the deceased spouse to escape estate taxes upon death.
Once the credit shelter trust is funded by the deceased spouse’s assets, the income is allocated to the surviving spouse. Upon the surviving spouse’s death, the credit shelter trust’s principal is distributed to the beneficiaries. In this way, it is similar to the Qualified Terminable Interest Property (QTIP) trust.
QTIP trust vs. credit shelter trust
As opposed to the QTIP trust, however, the credit shelter trust’s income can be allocated to beneficiaries other than the surviving spouse. In addition, the surviving spouse in a credit shelter trust can access the trust’s principal for health, education, maintenance, and support. Moreover, the surviving spouse in the credit shelter trust can be given a limited power of appointment to allocate the trust assets and decide the ultimate beneficiaries chosen from a class of beneficiaries. These characteristics make the credit shelter trust different from a QTIP trust.
Because other beneficiaries can be allocated the credit shelter trust’s income, the credit shelter trust’s assets are not part of the taxable estate of the surviving spouse upon death, in contrast with the QTIP trust where the income can only be used by the surviving spouse, making the QTIP trust’s assets part of the surviving spouse’s taxable estate upon death. Thus, in a credit shelter trust, there is no estate tax to be paid once it is distributed to the beneficiaries, as opposed to a QTIP trust where the surviving spouse’s estate pays estate tax on QTIP trust assets prior to distribution to beneficiaries. However, in a credit shelter trust, the basis of an asset remains at the time of the deceased spouse’s death, unlike in a QTIP trust where the basis of an asset is stepped up to the time of the surviving spouse’s death. This distinction can translate to a difference in thousands of dollars or even hundreds of thousands of dollars when a trust asset is later sold by the beneficiaries.
The fact that a QTIP trust does not give discretion to the surviving spouse to choose the ultimate beneficiaries makes the QTIP trust more attractive to blended families. In the QTIP trust, the settlor-deceased spouse can allocate the income of the trust to the surviving spouse (which is usually from the second or subsequent marriage), and upon that surviving spouse’s death, give the trust assets to his children (which is usually from the first or prior marriage), not giving the surviving spouse any power to choose or change the deceased spouse’s designated beneficiaries.
Examples and Illustrations
To understand the credit shelter trust more and its difference with a QTIP trust, here are some examples and illustrations.
For example, if you were previously married with children, and you are now on your second marriage with no children, you would like to provide for your surviving spouse upon your death, but upon your surviving spouse’s death, leave your assets to your children from your first marriage. You would not like your surviving spouse to have your assets, because, what if your surviving spouse gets remarried? The new spouse will ultimately get all your assets. What if your surviving spouse had children prior to your marriage? Those children will ultimately get your assets. In this case, a QTIP trust is a better choice for you because you are allowed to put up a trust, where the trust’s income is given to your surviving spouse for life, and only upon her death can your children from the first marriage receive the trust assets. Your surviving spouse does not have the power to change your designated beneficiaries.
Credit Shelter Trust
However, if you are a high net worth individual, you don’t have a blended family but only one family with one set of children with your spouse, and your only issue is to save on estate taxes, a credit shelter trust with a QTIP trust might be a more viable option for you.
For example, you have been married for the past 30 years to A. You and A have one child, B. On your own, you have a bank account worth $2,000,000, a Brooklyn Park Slope brownstone townhouse worth $8,000,000, and investments in stocks and bonds, worth $4,000,000. A, on the other hand, has a Manhattan apartment worth $500,000, a house in Hamptons worth $2,000,000, and a bank account of $500,000.
Currently, there is a federal estate tax exemption of $11.7 million in 2021. In New York, the basic exclusion amount is $5.93 million. For a net estate in excess of $5.93 million, the difference between the net estate and the basic exclusion amount is subject to estate tax. However, if your estate is more than 105% of $5.93 million or $6,226,500, your New York estate tax is based on the total amount and not the difference between the estate and the basic exclusion amount.
Example 1 – no estate planning
If you did not plan your estate, you would be subject to both federal and state estate taxes in the amount of $2,572,600 because your estate is worth $14,000,000. The taxable amount for your federal estate tax is your net estate of $14,000,000 less the exemption amount of $11,700,000 or $2,300,000. Your federal estate tax based on the table is a base tax of $345,800 plus 40% of the amount over $1,000,000 (which is $1,300,000) or $520,000, giving a total federal estate tax of $865,800.
You also need to pay state estate tax for New York. The basic exclusion amount in New York is $5,930,000 and the cliff is $6,226,500. Since your estate is more than $6,226,500, you pay state estate tax based on the total estate. The state estate tax for a taxable estate of more than $10,100,000 is $1,082,800 plus 16% of the amount over $10,100,000 or $624,000, giving a total state estate tax of $1,706,800.
Thus, for a net estate of $14,000,000, the total amount of federal and state estate taxes is $2,572,600.
Example 2 – credit shelter trust option 1
Suppose you planned your estate and decided on a credit shelter trust. Because the state estate tax is large, you decide to put in the trust the basic exclusion amount of $5,930,000 because this transfer is not taxable. You then decide to transfer the remaining assets of $8,070,000 to your spouse, A, to avail of the unlimited marital deduction. Upon death, there are no estate taxes to pay.
The credit shelter trust gives the income to your surviving spouse, A. It also provides that A can use the trust’s assets for her health, education, maintenance, and support during her lifetime. Upon death, the remaining trust principal is distributed to your common child, B.
Upon A’s death, she has her own estate of $3,000,000 consisting of the Manhattan apartment, the Hamptons house, and her bank account. The amount in the credit shelter trust is not subject to estate tax and will be distributed to B, using the basis at the time of your death. She also has the $8,070,000 from your marital transfer. A’s total estate upon death is $11,070,000, which is within the federal tax exemption. A will not pay any federal tax. However, A will have to pay state estate tax and is subject to the estate tax cliff. A’s total estate tax is $1,082,800 plus 16% of the difference between 11,070,000 and 10,100,000 which is $970,000 or $155,200, giving a total state estate tax of $1,238,000.
In this case, you will not pay estate tax, but your surviving spouse, A, for an estate of $11,070,000, will pay estate tax of $1,238,000.
Example 2 – credit shelter trust and QTIP option 2
Suppose instead that you put your Brooklyn brownstone townhouse worth $8,000,000 (which you bought for $4,000,000) in a QTIP trust, you put $5,930,000 of your money in the bank, stocks and bonds in a credit shelter trust, and the remaining $70,000 is transferred to your surviving spouse, A. The transfer to the QTIP trust and $70,000 to A are not taxable because they are considered marital transfers subject to marital deductions from your estate. The transfer to the credit shelter trust is not taxable because it is covered by the state’s basic exclusion amount. There are no estate taxes to be paid upon death.
When A dies, her estate is $11,070,000, coming from the Manhattan apartment, the Hamptons house, her bank account, the $70,000 from you, and the $8,000,000 Brooklyn brownstone in the QTIP trust, which she has to pay estate tax on. As computed earlier, the total state estate tax is $1,238,000.
After paying estate taxes, the Brooklyn brownstone, now with a fair market value of $12,000,000 upon A’s death, goes to B. B enjoys a stepped-up basis of $12,000,000 in the Brooklyn brownstone, as opposed to the previous example where no estate taxes were paid in the credit shelter trust, however, B retains the $8,000,000 basis at the time of your death. When B decides to sell the Brooklyn brownstone for $12 million, there is no capital gains tax because his adjusted basis is $12,000,000. If the Brooklyn brownstone was placed in a credit shelter trust instead of a QTIP trust, B’s basis would be $8,000,000 and if he sells it for $12,000,000, he will have a tax rate of 37% for the capital gain of $4,000,000, which is $1,480,000.
Example 3 – estate planning option 3
In this case, we use the same example above. You leave your Brooklyn browstone in a QTIP trust, you put $5,930,000 of your money in the bank, stocks and bonds in a credit shelter trust, and the remaining $70,000 is transferred to your surviving spouse, A. No estate taxes are paid.
Your surviving spouse, A, is left with an estate of 11,070,000 upon her death, consisting of the Manhattan apartment worth $500,000, the Hamptons house worth $2,000,000, the bank account of $570,000 (which includes the $70,000 from you), and the $8,000,000 Brooklyn brownstone in the QTIP trust.
A planned her estate and put the $570,000 bank account on a Transfer on Death account, where your common child, B, would immediately receive the proceeds upon her death without going through probate. She transferred the Hamptons house and Manhattan apartment in an irrevocable trust for the benefit of her child, B. Upon her death, only the $8,000,000 Brooklyn Park Slope brownstone in the QTIP Trust was part of her estate. In this case, her estate will not pay any federal tax, and her state estate tax would only be 650,800 plus 13.6% of the amount over %7.1 million for a total of $773,200. When B later on sells the Brooklyn Park Slope townhouse for $12 million, he will enjoy the adjusted basis of $12million and he will not have to pay any capital gains tax.
With proper estate planning, your entire family saves close to $500,000 on taxes based on the scenarios above.
Ultimately, with large estates, estate taxes have to be paid, unless prior planning was made more than 3 years before your death (because gifts made within 3 years from death are included in the taxable estate). Still, there are a lot of considerations that need to be taken into account, and a balancing act has to be made on whether you prefer to pay a smaller estate tax and your child will pay a lower capital gains tax when a property is sold. There will always be ways to reduce your estate or reduce your capital gains tax by putting some of your properties in trusts. If you need advice in planning your estate, we, at the Law Offices of Albert Goodwin, are here for you. We have offices in New York, NY, Brooklyn, NY, and Queens, NY. You can call us at 718-509-9774 or send us an email at firstname.lastname@example.org.