Credit Shelter Trusts- What are they and are they still relevant?

Credit shelter trusts (CST) are an interesting trust planning concept, created out of the need to make maximum use out of both spouse’s estate tax exemptions. However, with the increase in the US estate tax exemption and the introduction of “porting” of an unused spouse’s exemption by the surviving spouse, are these types of trusts even relevant? Well, the big question is, it depends on where you live and where you own assets.

CST & Estate Tax

In the United States, we have two different types of estate taxes to deal with: the federal estate tax and a state estate tax. The federal estate tax is particularly noteworthy for its high level of tax, taking a bite of up to 40% of the fair market value at the date of death. Eighteen states, including New York and New Jersey, currently impose some form of estate or inheritance tax, New York’s estate tax ranges from 3.06%- 16%.

So what tax will you be owing to the IRS and the state authorities? First, some good news. With a federal exemption of up to $11.5mm per person currently in place, combined with a state exemption in New York of $6mm, it is unlikely that most people will owe any estate tax, period. However, if you and your spouse do so happen to have assets exceeding these amounts, the “credit shelter” strategy may be an option worth considering.

At the death of the first spouse, anything that the surviving spouse inherits is passed on tax-free, regardless of state or federal exemptions. This is known as the “unlimited spousal exemption.” On paper, it sounds like a great tax break for your spouse, but it’s not so much of a tax break as it temporarily kicks the can down the road, as upon the surviving spouse’s death, there could be a massive (and avoidable) estate tax due.

Credit Shelter Trust Example

Let’s take a simple example: Spouse A and B are married, living in New York, and each have assets in their name of $11.5mm, totaling $23mm. Spouse A passes away leaving his entire estate to Spouse B. Due to the unlimited marital exemption, Spouse B will pay zero estate tax on this transfer, and as such would not utilize any of Spouse’s A’s $11.5mm federal exemption or New York’s $6mm exemption. However, Spouse B will subsequently be the owner of $23mm in assets. Upon Spouse B’s death, transfers to a non-spouse such as children, will be subject to US estate tax on any amount over $11.5mm ($4.6mm federal estate tax bill) and will also be subject to a NYS estate tax bill of up to 16% of the assets.

It seems unfair that due to the unlimited spousal exemption that the surviving spouse loses the deceased spouse’s exemption, simply because of the deceased spouse’s generosity in providing for the surviving spouse. This anomaly was fixed on the federal level several years ago, allowing for the surviving spouse to “port” the deceased spouse’s unused exemption. However, the anomaly was never fixed on the state level, so for the NYS estate tax, it’s either “use it or lose it” at the time of the first to die, spouse.

Credit Shelter Planning in New York

This is where credit shelter planning comes into place. The basic idea is that a certain portion of the deceased spouse’s estate, typically up to the state exemption amount, is not transferred directly to the surviving spouse, but is maintained in a “credit shelter trust,” (“CST”) typically for the benefit of the surviving spouse and descendants. As this portion is being held in such a trust, it is considered a part of the deceased spouse’s taxable estate, utilizing his/her exemption.

Thus, returning to our example above. Spouse A passes away, leaving an estate of $11.5mm. Spouse B would directly receive $5.5mm, with the remainder balance being kept in the CST. There would be no estate tax owed at the death of Spouse A. On Spouse B’s death, any amount in the CST, including appreciation of such assets, would not be considered as part of Spouse B’s estate, and exempt from future federal and state estate tax. Spouse B would typically spend down assets in his/her own name or engage in additional planning of such assets to further decease or eliminate any future estate taxes.

Not only does the CST help to mitigate estate taxes, it is also a useful planning tool for blended families, ensuring assets are eventually inherited by children from a previous marriage, as well as having the potential to protect the beneficiary’s interests from their creditors.

New York Trusts & Estate Planning Counsel

It is important to consider, this is an over-simplified explanation of the CST concept, and no such planning should be attempted without the advice of an experienced trusts & estate planning lawyer. The legal team at Chaves Perlowitz Luftig is here to guide you! We even offer free initial consultations so you can really understand all your options. Contact us online or at (212) 791-3747 today.