Wealth of Knowledge - Spring 2014 - Portability and Credit Shelter Trusts

March 25, 2014

By Karen L. Goldberg

At the recent Heckerling Institute on Estate Planning, Thomas W. Abendroth of Schiff Hardin LLP spoke about portability, which refers to the estate tax provision that effectively allows a surviving spouse to “inherit” her deceased spouse’s unused estate tax exclusion (“DSUE”).  Portability was intended to simplify estate planning so that married couples can leave their property to each other without losing their respective estate tax exclusions.  In the past, to preserve the estate tax exclusion of the first spouse to die, a married couple would retitle their assets so that each spouse separately owned cash/property at least equal to the estate tax exclusion.  In addition, their wills would provide that upon the death of the first spouse, cash/property equal to the estate tax exclusion would go to a trust for the benefit of the surviving spouse and children (known as a “credit shelter trust”).  This trust was designed to use the predeceased spouse’s estate tax exclusion to shelter the trust assets from estate tax in both spouses’ estates. If instead, the first spouse to die left all his property outright to his surviving spouse, his estate tax exclusion ($5 million+ since 2010) would be wasted, and all of the property inherited by the surviving spouse would be taxable in her estate without any reduction for the predeceased spouse’s unused estate tax exclusion. 

Mr. Abendroth pointed out that the surviving spouse can only use the DSUE of her last-deceased spouse.  This means that if the surviving spouse remarries and her second spouse predeceases, she is only entitled to the second spouse’s DSUE.   Nevertheless, a surviving spouse who outlives multiple spouses can use the DSUE of each of those deceased spouses if she makes lifetime gifts using the DSUE of her most recently deceased spouse before her next spouse predeceases.  The surviving spouse will be deemed to use the DSUE before her own gift tax exclusion.

Mr. Abendroth discussed the advantages of portability as compared to a credit shelter trust.  First, portability affords simplicity.   A married couple can leave all their property to each other without losing the estate tax exclusion of the first spouse to die.   They don’t have to provide for a credit shelter trust under their wills and retitle their assets so that each spouse has sufficient assets to fund the trust with the estate tax exclusion amount.   Second, any assets that go to the surviving spouse, rather than to a credit shelter trust, receive a second step-up in basis on the surviving spouse’s death; this is not the case for any property that goes to a credit shelter trust.  Third, in estates where most of the assets consist of retirement plans and residences, funding a credit shelter trust can pose challenges: Retirement plans have an inherent income tax liability, and minimum distribution requirements can make such plans less than ideal candidates for a credit shelter trust.  A residence poses practical issues, including how to fund the ongoing maintenance expenses of the home.

Next, Mr. Abendroth discussed the advantages of a credit shelter trust as compared to portability.   First, a credit shelter trust protects future appreciation in the trust assets from estate tax in the surviving spouse’s estate.  By contrast, the DSUE amount is not indexed for inflation; this means that only the DSUE amount existing at the predeceased spouse’s death can be used by the surviving spouse.  If the assets inherited from the predeceased spouse have appreciated above the DSUE amount, that appreciation is taxable in the surviving spouse’s estate.  Second, the generation-skipping transfer tax (“GST”) exemption is not portable.  As a result, if the predeceasing spouse has not used his GST exemption during life, it will be lost at death if he leaves all of his property to his surviving spouse, and simply relies on portability to preserve his estate tax exclusion.  A credit shelter trust structured as a generation-skipping trust preserves the GST exemption of the first spouse to die.   Third, if a surviving spouse remarries and her second spouse also predeceases, she will only be entitled to the second spouse’s DSUE, and the first spouse’s DSUE will be lost if she hasn’t already used it for gifts.  However, the surviving spouse’s remarriage does not affect a credit shelter trust and in fact, the surviving spouse can accumulate multiple credit shelter trusts if she remarries and survives multiple spouses.  Fourth, a trust provides creditor protection as well as protects the assets from the misappropriation or misuse by children.  Lastly, if the credit shelter trust is funded with difficult-to-value assets, the audit risk with respect to their value is reduced because of the nontaxable nature of the estate.   It also allows a family that has a closely held business to divide a controlling interest by transferring an interest in the company to a credit shelter trust so that when the surviving spouse dies she only has a non-controlling interest that should be eligible for valuation discounts.

Mr. Abendroth indicated that portability is most attractive for couples whose assets are unlikely to exceed twice the estate tax exclusion.   However, if they reside in a state with a low state estate tax exclusion, such as New York ($1 million) or New Jersey ($675,000), he suggested that the couple may want to fund a credit shelter trust with the state estate tax exclusion amount on the first spouse’s death to save state estate tax on the second spouse’s death.  Furthermore, where a couple has assets above or near the threshold for incurring estate tax and the first spouse to die leaves unused exclusion, portability can be used to preserve that unused exclusion.  This often happens when a couple fails to retitle assets or the nature and size of their assets don’t allow them to do so, and they can’t fully fund the credit shelter trust upon the first spouse’s death.  

In light of the unique nature of every client’s assets and family situation, it is difficult to reach broad general conclusions with respect to the advisability of portability.   Nevertheless, practitioners should view portability as another tool in the planning process which may be advantageous for their clients.

Wealth of Knowledge - Spring 2014

About Karen L. Goldberg

Karen L. Goldberg in the Private Wealth Advisory Group leads the trust and estate practice in the New York office. Karen specializes in estate planning for closely held business owners, senior corporate executives and other high net worth individuals.

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