One of the most common trusts that estate and elder law practitioners have used to address estate taxes is a Credit Shelter Trust. This type of trust is also commonly referred to as a By-Pass Trust. A credit shelter trust can be structured to require distributions of income to the surviving spouse during his or her lifetime and can allow for the distribution of principal, subject to the discretion of a trustee.
Prior to New Jersey’s repeal of the Estate Tax, the rationale behind the use of a credit shelter trust started with recognition that under state law (1) estate taxes were not imposed when assets of any amount pass to a surviving spouse, (2) the exemption amount was an amount that was available to each spouse, and (3), if all of a deceased spouse’s assets were left to his or her spouse, the value of his or her exemption amount would be lost. Specifically, if one spouse died and left all assets to the surviving spouse, no estate tax would be imposed regardless of the size of the estate. The deceased spouse’s exemption amount, however, would die with the deceased spouse. For example, under the law in effect for people who died prior to January 1, 2017, even though both spouses had $675,000 exemptions for a total of $1,350,000, by the time the second death occurred only one $675,000 exeption would remain available to shelter the assets passing to children and/or grandchildren from estate taxation.
If, on the other hand, the deceased spouse’s will included a credit shelter trust and part of the surviving spouse’s inheritance was allocated to the credit shelter trust upon the first death, the deceased spouse’s exemption would be preserved. For example, under the law in effect for people who died prior to January 1, 2017, if a husband and wife owned assets valued a $1,500,000, and $675,000 of the assets were directed into a credit shelter trust upon the death of the husband, at least $1,350,000 would be insulated from estate taxes. Specifically, if upon the second death (the death of the wife) her assets were worth $800,000, her $675,000 exemption would insulate all but $125,000 from estate taxes. As to the assets in the credit shelter trust, all of these assets would be insulated from estate taxes, even if the value of the assets had appreciated to more than $675,000. In other words, the estate would receive the benefit of the wife’s $675,000 exemption and of the husband’s $675,000 exemption.
The amount allocated to the trust can be determined by a formula set forth in a will or by the surviving spouse by a disclaimer. Given the fluctuations in people’s net worths and the equally unpredictable nature of tax policy, funding a credit shelter trust through a disclaimer is an appealing and commonly utilized approach.
Existing wills should be evaluated to determine whether they have Credit Shelter Trust provisions and the circumstances under which the trusts will be funded. If a trust contains a formula provision, the trust may not only have to be funded without achieving any estate tax benefit, but may also trigger another tax detriment, such as a future increase in capital gains taxes.
Existing wills that have Credit Shelter Trust provisions, but that allow a surviving spouse to choose to fund the trust through a disclaimer upon the first death, do not pose any risk of funding the trust when there is no benefit and some detriment to doing so. Such provisions, in fact, provide flexibility and protection as tax laws change, (for example, if the New Jersey Estate Tax is reinstated).
In this regard, it is still reasonable to consider including Credit Shelter Trust provisions in new wills to provide a flexible means of addressing future changes in the tax law.