Credit Shelter Trusts (or Bypass Trusts)
Credit shelter trusts or bypass trusts are used only between spouses when needed. The credit shelter trust is really a layman's term for a method of being sure both spouses take advantage of the estate tax unified credit amount.
When federal transfer taxes are computed on your estate, your estate is actually granted a tax credit equal to the savings account discussed in Chapter 17. When you create a credit shelter trust or a bypass trust, you are creating a trust that uses the tax credit associated with the savings account amount, thus sheltering or protecting your assets from taxes. That is why it is called a credit shelter trust. Don't worry; as you continue reading, these concepts will become understandable.
If you add your taxable base to the taxable base of your spouse, and the total exceeds one savings account amount or unified credit exclusion, you should definitely consider using credit shelter trusts.
A credit shelter trust is not a separate trust, but is created within a revocable trust. While you are alive, you are your own trustee and have full control over the trust property. When you die, the successor trustee takes over and begins following the instructions you put in your trust document. The credit shelter trust comes into being when you die if the combined taxable bases of you and your spouse exceed one savings account amount. This savings account is based on the allowable exclusion for the year in which you die. In 2009 the exclusion is $3.5 million each, but that will change in 2010, 2011, and possibly in later years.
If your taxable base plus the taxable base of your spouse is less than one savings account amount, your successor trustee will probably be instructed to transfer the entire balance of your trust to your spouse's trust or to your spouse outright since you don't need a credit shelter trust to reduce your estate taxes. It is only when your surviving spouse would have a taxable base larger than the exclusion amount that you need to create a credit shelter or bypass trust for estate tax planning.
When you die, your revocable trust becomes irrevocable. If you have created a credit shelter trust, the terms of that trust will include instructions in the trust document. Those instructions will tell your successor trustee to look at your surviving spouse's potential taxable base. There are two possible sets of instructions that could be given, depending on the combined taxable base of you and your spouse.
The First Set of Instructions
The first set of instructions would cover the situation in which the combined taxable base of your estate plus your spouse's estate in 2011 (and possibly beyond) is between $1 million and $2 million. If this occurs, the first thing your successor trustee will do is calculate what your surviving spouse's taxable base would be if she died.
Perhaps there are reasons other than tax savings for not giving your spouse access to all your property. In that case, you may instruct your successor trustee to keep your property in trust to be managed for the benefit of your spouse or your other beneficiaries after you are gone.
Remember, upon your death your spouse might receive property from sources other than your trust. If your spouse receives insurance proceeds, annuities, or retirement accounts because of your death, those amounts should be included in her taxable base. The successor trustee will then be instructed to transfer enough property from your trust to your surviving spouse or her revocable trust to leave her with a taxable base equal to the tax exclusion figure in the year of your death.
Suppose in 2011 the combined taxable base of you and your spouse is $1.5 million, and you die in that year. Your trustee should direct to your credit shelter trust the amount that would exceed $1 million of your surviving spouse's base. This is a good way to take advantage of your unified credit or savings account.
For example, assume your surviving spouse has a $700,000 taxable base. This taxable base already includes insurance, annuities, or retirement plans your spouse received because of your death. Assume your taxable base is $800,000. If the exclusion is still $1 million, your trustee would transfer $300,000 of your trust property to your spouse. This would give your spouse a taxable base of $1 million (your $300,000 plus her $700,000) and no tax due. Your credit shelter trust now has $500,000 remaining (your taxable base of $800,000 minus the $300,000 transferred to your spouse's trust). The credit shelter trust provides income to your spouse but is not part of her taxable base.
The Second Set of Instructions
The second set of instructions tells your successor trustee what to do if the combined taxable base of you and your spouse is over $2 million. If your combined taxable bases exceed $2 million at your death, your successor trustee will be instructed to transfer all of your trust property over $1 million to your spouse's trust.
Don't move everything in your estate to the surviving spouse's trust. You could be limiting your spouse's outright access to funds he might want or need.
As another example, let's assume your taxable base is $1.2 million and your spouse's taxable base is $1.1 million when you die. Your successor trustee would keep $1 million in your credit shelter trust and transfer $200,000 to your spouse or her revocable trust. The $200,000 is deducted from your taxable base because you can deduct property you give to your spouse. This would leave your estate with a taxable base of $1 million. Your estate would pay no taxes because the taxable base equals the unified credit exclusion.
If your surviving spouse is left with a taxable base of more than $1 million she should then be able to do some planning to reduce her taxable base below $1 million.
These examples assume that neither you nor your spouse made any taxable gifts during your lives that would reduce the available gift exclusion when you die. Of course, property can increase or decrease in value after being transferred to your spouse or her trust. You may want to give your spouse the opportunity to spend down the estate or to make more annual gifts.
Power over the Trust Property
In the first example, you had $500,000 left in the credit shelter trust. In the second example, there is $1 million the maximum exclusion amount, in the credit shelter trust. The credit shelter trust is irrevocable after you are gone. Your successor trustee will manage the money or property in the trust for the benefit of your family according to the instructions you put in the document.
You cannot name your spouse as successor trustee of your credit shelter trust. If you do, the credit shelter trust will be included in your spouse's taxable base when he dies, and you will have wasted your time creating it. Your spouse should not have full control over the credit shelter trust property, but the trustee can usually provide funds as needed in line with your instructions.
You can give your trustee any of the powers that are described in Chapters 11 and 12 over the trust property. As you may recall, you can be very specific about how, when, and why your successor trustee distributes the credit shelter trust money and property for your spouse, your children, or other beneficiaries you might name. But, frankly, what most people want is to provide the surviving spouse with as much access to the property in the credit shelter trust as possible.
You can give your spouse the absolute right to all of the income from the property. In addition, you can give your trustee the power to distribute as much money or property from the credit shelter trust as your spouse needs for her health, education, maintenance, or welfare. And you can give your surviving spouse the right to demand the greater of $5,000 per year or 5 percent of the value of all of the credit shelter trust assets. This power to demand is in addition to the other rights and powers.
