Estate taxes are likely remain in a state of flux for as long as Congress plays politics. Combining this popular topic for procrastination (planning for death) and change, the result may be an accident waiting to happen.
A bit of housekeeping may be in order for those who took the good advice of their attorneys and financial advisors several years ago, and set up a Credit Shelter Trust, By-Pass Trust or AB Planning, as part of their estate planning to minimize estate taxes. Changes in the law over the years have rendered much of that planning obsolete, and potentially dysfunctional.
Trusts can serve many purposes including creditor protection and control and management of assets after death. From an estate tax perspective, however, many trusts were setup solely to receive and hold assets from the 1st spouse (of a married couple) at his or her death, preserving his or her estate tax exemption which would have been lost if all assets passed directly to the surviving spouse. Assets in this Credit Shelter Trust could grow free of estate tax for the benefit of the surviving spouse and the couple’s children.
Legislation passed on January 2, 2013 renders this type of estate plan obsolete for a majority of married couples. Just ten years ago, an individual could transfer only $1,500,000 to a non-spouse beneficiary.
Under current law, that amount increased to $5.43 million and a surviving spouse can “port” the 1st-to-die’s estate tax exemption taxes by making an election on an estate tax return. Portability of the federal estate tax exemption means that a surviving spouse gets to use what their deceased spouse did not use as well as their own estate tax exemption. In other words, a married couple may now pass up to $10.86 million without having to pay estate taxes.
For the married couples who have not reviewed their estate plans since the passage of this new legislation, a Credit Shelter Trust may no longer be necessary and probably presents complexities and potentially avoidable capital gains taxes. For example, a common problem for the Credit Shelter Trust approach was the need to divide assets between spouses so that individually owned assets could fund the trusts. There is no need to separate assets to fund AB Trusts with the advent of portability.
Perhaps the most onerous unintended consequence of ignoring your old Credit Shelter Trust is the potential for unnecessary capital gains tax. Consider that a person’s assets receive a step-up in basis at death. However, assets that fund a Credit Shelter or By-Pass trust at a 1st spouse’s death will not be stepped up again at the 2nd spouse’s death, subjecting any appreciation of such assets to capital gains taxes when sold by the children after the surviving spouse’s death.
To illustrate, assume a couple’s estate is worth $2,000,000, with $1 million in each spouse’s name. The husband dies. His will says that his Credit Shelter Trust will be funded up to the “applicable exclusion amount,” so all of his assets go into trust for the benefit of his surviving spouse and children. If his wife lives another 10 years, the trust assets could reasonably double. Upon her death the trust’s assets will be paid to their children, but without the step-up in basis on the $1 million of gain. The children will pay about $200,000 in capital gains taxes that could have been avoided if their parents had eliminated the Credit Shelter Trust planning.
If the objective of your Credit Shelter Trust planning is to minimize estate taxes, it might be a good idea to review your plans. Relying on portability rather than a Credit Shelter Trust requires careful analysis and thought (and there are pitfalls for the unknowing!), but an estate plan providing for distribution of all assets outright to the surviving spouse combined with the portability provision in the American Tax Relief Act of 2012, might accomplish the same estate tax relief without creating capital gains taxes unintentionally.
Many thanks to John W. Forneris, an estate planning attorney at Robinson Bradshaw & Hinson for reviewing this essay.
1 About Money.com, Exemption from Federal Estate Taxes: 1997-2015, Table Showing Federal Estate Tax Exemption and Rate: 1997 – 2015, http://wills.about.com/od/understandingestatetaxes/a/estatetaxchart.htm
2 Nothing in this essay should be construed as tax or legal advice. This information is intended to highlight a potential issue with estate plans established in prior years. Consult your attorney, tax, or financial advisor to discuss your circumstances in the context of these developments.