Definition and Example of a Credit Shelter Trust
The Credit Shelter Trust is a tax structure wealthy individuals can utilize to minimize the estate tax their heirs will need to pay to the IRS. The Credit Shelter Trust, also known as an AB Trust or Bypass Trust, leverages the unlimited marital deduction and the tax trust structure to minimize taxation on the deceased’s assets.
Alternate names: AB Trust, Bypass TrustAcronym: CST
For example, consider married couple Ned and Nancy and their son, Nate. Ned and Nancy are each worth $8 million, and their combined net worth of $16 million dollars exceeds the estate tax exemption for individuals, meaning their son might face a significant estate tax bill once both his parents have passed. Therefore, Ned might have a CST drawn up to shelter his $8 million estate upon his death, which will pass to Nate, tax-free, upon Nancy’s death.
How Credit Shelter Trusts Work
Under current U.S. law, the highest estate tax rate is 40 percent of the value of the estate that exceeds $11.7 million—this is the current estate tax exemption amount. However, spouses can gift each other their estates tax-free at any time, including when one of the spouses dies. The CST is designed to take advantage of these rules in order to minimize the eventual tax rate heirs will be required to pay. Once a CST is drawn up, assuming the spouses hold their assets independently, the assets of the spouse to die first will transfer to the trust rather than to the surviving spouse. The CST is then controlled by a trustee, but is designed to benefit the surviving spouse during their lifetime by providing income, for example, and allowing access to funds for medical and educational expenses. Since the deceased spouse’s assets were transferred to a trust rather than to the surviving spouse, the estate did not increase the surviving spouse’s tax basis. Upon the death of the second spouse, therefore, the remaining assets in the CST will transfer to the heirs tax-free, minimizing the heirs’ tax burden. As long as the value of the second spouse’s estate remains below the estate tax exemption amount, it, too, can transfer to the heirs without being subject to estate tax.
Detailed Example of a Credit Shelter Trust
Let’s return to our example of Ned and Nancy and their son, Nate. Upon Ned’s death, he can bequeath his estate of $8 million to Nancy free of tax due to the unlimited marital deduction. The addition of Ned’s assets, however, would increase Nancy’s estate to $16 million, which exceeds the federal limit of $11.7 million and would impose a significant estate tax burden on Nate upon Nancy’s death. Therefore, Ned decides to have his attorney form a CST on his behalf. Upon Ned’s death, his $8 million dollars would transfer to the trust under the control of his attorney, who he establishes as the trustee. Nancy would be able to access the income from the trust and use the principal for qualifying expenses until her death. If Nancy’s net worth upon her death is $8 million dollars, Nate would be spared the tax rate he would have been obligated to pay on an estate over $11.7 million. The funds in Ned’s CST would also transfer to Nate at this point and not be subject to tax.
Pros and Cons of CSTs
The CST’s benefits are obvious, but there are also downsides. First, the CST is expensive to form, typically requiring hefty fees to tax attorneys and accountants. Second, the CST effectively deprives the surviving spouse control of the deceased spouse’s estate because the assets are now overseen by the trustee. Nevertheless, the CST remains a popular option for couples that hold significant assets.
