What are credit shelter trusts?
A credit shelter trust (CST) is a trust created after the death of the first spouse in a married couple. Assets placed in the trust are generally held apart from the estate of the surviving spouse, so they may pass tax-free to the remaining beneficiaries at the death of the surviving spouse. The assets held in the CST can benefit the surviving spouse during their lifetime. Credit shelter trusts are also commonly known as bypass, family, or exemption trusts.
How do they work?
Because transfers to surviving spouses are generally free from federal estate tax, CSTs can be used in conjunction with the unlimited marital deduction. At death, if the executor or trustee is directed to fully fund the CST, assets totaling the deceased spouse's available lifetime federal gift and estate tax applicable exclusion amount would be transferred to a CST for the benefit of the surviving spouse for their lifetime. When the surviving spouse dies, the trust assets will pass tax-free to the CST beneficiaries. The CST shelters the assets and any appreciation in the value of the assets from inclusion in the surviving spouse's estate.
To derive the maximum federal estate tax benefit, each spouse should own enough assets in their own name so the value of each spouse's assets meets (to the fullest extent possible) or exceeds the applicable exclusion amount.
CST vs. portability
At the election of the surviving spouse, the Internal Revenue Code provides for the transfer of the first-to-die spouse's unused applicable exclusion amount to the surviving spouse, who can then use it for their gift or estate tax purposes.* Although relying on portability may be easier than creating and administering a CST, a CST has several advantages over electing portability:
- All appreciation in the value of the assets in the CST bypasses the surviving spouse's estate and will not be subject to federal and/or state estate taxes at the surviving spouse's death.
- Portability is generally not permitted for state estate tax exclusions (for states that levy state estate tax) and the federal generation-skipping transfer tax exclusion. Therefore, without the use of a CST, any unused state estate tax exclusion and generation-skipping transfer tax exclusion of the first spouse to die will be lost.
- Assets contained in a trust are generally protected from the beneficiary’s creditors.
- The first spouse to die can control where the assets remaining in the trust are distributed after the surviving spouse’s death rather than relying on the surviving spouse to carry out the wishes of the first spouse to die.
When consulting with your attorney or tax advisor, consider the possible downsides to a credit shelter trust:
- Income tax returns must be filed for the trust in order to obtain the benefits of a CST. If the assets that are used to fund the trust are complicated, such as a retirement planning asset, this filing can be cumbersome and expensive.
- The tax basis of the assets in a CST is stepped up only once—at the death of the first spouse—unlike with portability, where the tax basis would be stepped up a second time upon the death of the second spouse.
- The surviving spouse must be willing to accept only certain rights and limited control over the assets in the trust. Generally speaking, they can access all of the trust’s income, and as the trustee, can draw on the principal to pay for health, education, maintenance, and living expenses. If the trustee is someone other than the surviving spouse, typically that spouse may receive trust assets for other reasons at the trustee's discretion.
- The Tax Cuts and Jobs Act of 2017 may impact the amount of assets that flow to a CST. If a CST is automatically funded, the amount of assets that might be more readily available to the surviving spouse may be reduced or eliminated due to the increase in the applicable exclusion amount. Consider speaking with your attorney to understand how this impacts your situation.