Estate planning should not be a one-size-fits-all approach. There's no question that everyone needs to do some estate planning; however, appropriate methods and plans are often quite different. The primary concern for some people is ensuring that their wishes (post-death) about "who gets what" are carried out. Others are concerned about caring for and providing for loved ones they may leave behind. And still, others may desire to eliminate or limit estate taxes. There may also be concerns about privacy and the estate administration cost or philanthropic endeavors. The list is abundant, as is the required forethought and planning. Even as the state in which you live impacts your estate planning.
Each of our lives has its own little (sometimes big) complications that may further motivate us to do specific things in our estate planning. Ongoing responsibilities are a significant factor in how we plan. Our age, health, whether we have minor children, etc., are all factors that may require us to have contingency plans and make provisions in the event of our death. This article aims not to address all aspects of estate planning exhaustively, but to focus on one area of concern - particularly related to plans completed several years ago.
The focus of this article is the sometimes-unnecessary use of a bypass trust (also called an "A/B Trust" or a "Credit Shelter Trust") which could result in your heirs paying higher federal income taxes than necessary. Sometimes even well-intentioned plans can do more harm than good. There is truth to the old saying, "If it ain't broke, don't fix it." While a Credit Shelter Trust (CST) is a useful tool for some estates, they are unnecessary for others. If your estate plan includes funding a CST, you may want to take a fresh look at your plan to ensure it accomplishes what you intended.
Several years ago, a popular estate planning strategy was to establish a Credit Shelter Trust, to which the maximum federal estate tax exemption of the deceased was directed, with the remaining estate generally going to a Marital Trust (utilizing the Marital Exemption). This strategy aimed to ensure full use of the deceased's estate tax exemption amount, thereby limiting how much the survivor's estate would eventually have to pay in federal estate taxes upon their death. While not all trusts are the same, most provided for income from the CST to be paid to the survivor during their lifetime with some limited provision for invasion of principal based on need. The CST would have a Trustee (not the surviving spouse) tasked with making all decisions concerning the trust.
In the last few years, several legislative changes were made to reduce the threshold for concerns over the federal estate tax. One such change was the significant increase in the estate tax exemption amount (in 2022, it is $12.06 million per person). For example, when estate plans were done in 2001, the exemption amount was only $675,000. Also, back then, the survivor of a married couple could not share an unused exemption amount of the first to die. More recent legislation (The American Taxpayer Relief Act of 2012) has made "portability" of the exemption between spouses possible. In 2022 this portability of a married couple's exemption amounts effectively gives the couple up to $24.12 million of exemption before they would owe any federal estate tax. Most couples in the U.S. do not come close to that estate size.
The very generous exemption amounts currently available are only available through 2025. Under current law, they will revert to the $5 million level, adjusted for inflation, likely translating to around $6 million per person. With portability, which was made permanent in 2012, a married couple's estate could still be approximately $12 million without being subject to estate tax after 2025. Additional legislative proposals may further change and complicate planning. Keeping up with these changes and staying flexible is essential.
Generally, the tax basis of an inherited non-qualified (non-401k, non- IRA, etc.) asset becomes the fair market value of that asset as of the date of death. That change in basis is often referred to as the step-up in basis. The term "step-up" is used because most assets will appreciate over time such that the current fair market value exceeds their original cost basis. As a result of the step-up in basis, when the heir sells the asset, they will not have to pay any income tax on the gain due to appreciation from the time the deceased purchased the asset through the date of death. If that asset had been held for a long time, that could be a very substantial amount.
The funding of a CST, or any other irrevocable trust, can have some negative federal income tax consequences that must be considered. Assets placed in a CST at the time of the first spouse's death are given a new basis at that time, based on the then fair market value. However, when the second spouse dies (potentially many years later), and the assets in the trust pass on to the heirs, there is no further step-up in basis allowed. While transferring assets to an irrevocable trust will result in a loss in the step-up basis, there may be non-tax related reasons one might still want to avail themselves of a trust structure such as creditor protection, which includes the spouse of a failed second marriage. You should consult with qualified counsel to assist you with planning for your specific needs and circumstances.
To summarize the concern, using a Credit Shelter Trust for the average U.S. couple may do more harm than good. If their combined estate value is less than the exemption amount, they won't owe federal estate taxes anyway. However, funding the CST will lock in a potentially lower tax basis, eventually costing the heirs more in federal income tax when they sell the inherited assets. For example, assume Spouse 1 dies and $1,000,000 of assets go into a credit shelter trust. Assume ten years pass, and the portfolio appreciates approximately 6% per year. At the end of the 10th year, Spouse 2 dies and the portfolio in the CST is worth $1,790,848. The assets are distributed to the heirs and sold for fair market value ($1,790,848). The heirs will have a long-term capital gain of $790,848 and, assuming a 23.8% (20% capital gains tax rate plus 3.8% Affordable Care Act tax rate) federal tax rate, will pay $188,222 in federal income tax. Had a CST not been used in the example above, the estate would still have owed no federal estate taxes, and there would have been no taxable gain on sale and, therefore, no federal income tax owed by the heirs.
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