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Credit Shelter Trust A Credit Shelter Trust is a receptacle for property that will pass tax free to descendants or other beneficiaries because of the federal estate tax exemption. The exemption currently is $2,000,000 per donor. As with any trust, the Credit Shelter Trust provides flexibility in making distributions to beneficiaries, including the ability to take into account special circumstances and needs of beneficiaries arising subsequent to drafting or amending the trust. It can optionally provide additional tax minimization and debtor protection features for beneficiaries as with Spendthrift and Special Needs Trusts and Generation Skipping Trusts. The Credit Shelter Trust has advantages for married persons. It allows the surviving spouse as primary beneficiary to benefit from the trust without the property being included in her estate, and hence taxed, at her death. For this reason it is sometimes referred to as a Bypass Trust. Children or other descendants are usually specified as remainder beneficiaries. The Credit Shelter Trust concept applies as well to primary beneficiaries other than surviving spouses. The credit shelter trust is also sometimes referred to as the family trust. The trust is funded during life or at death with property titled in the decedent's name. It is normally funded up to the estate tax exemption amount. Funding above this amount is sometimes done in large estates to equalize spouses marginal estate tax rates, thereby reducing combined tax exposure. If the trust is funded during the donor's life it removes subsequent appreciation of the funds from his estate (thereby reducing exposure to transfer taxation).The trust can be structured so the donor pays the income taxes on trust earnings - providing additional transfer tax relief. To qualify for bypass treatment beneficiary interests in the trust must be limited. Beneficiaries can have the income of the trust, any additional amounts required for health, support, education and maintenance, and a limited right to select remainder beneficiaries. If more flexibility is needed an independent trustee or a remainder-beneficiary cotrustee can be used to provide additional amounts from the trust corpus. If the primary beneficiary is unlikely to need benefits from the trust it can be disclaimed if done in a timely manner thereby allowing the property to pass directly to remainder beneficiaries. This would avoid taxation in the estate of the primary beneficiary of trust proceeds otherwise required to be distributed to the primary beneficiary according to the terms of the trust. Alternatively, an independent trustee can be used to provide flexibility in allocating Bypass Trust benefits among beneficiaries. Another option would be to leave the surviving spouse (or other primary beneficiary) out of the Bypass Trust altogether. The advantage is that it wouldn't depend on the beneficiary timely executing a valid disclaimer. At the other extreme is a situation where the primary beneficiary's resources may be so limited that she is likely to need all the Bypass Trust property during her life. In this case the Will or Living Trust document can specify that the Bypass Trust is to be funded (i.e., created) only in the event the primary beneficiary disclaims an outright bequest. Thus, upon the death of the donor, if the primary beneficiary found she needed all the bypass property during her life she would simply accept the outright bequest. Otherwise, she could disclaim and the Bypass Trust would be created and funded - giving her protection in the future if her own resources became depleted. The Marital Deduction Trust The decedent spouse's estate over and above the amount that funds the Bypass Trust can pass tax-free either outright or in trust to the surviving spouse because of the unlimited marital deduction. Marital deduction assets thereafter remaining in the surviving spouse's estate at her death are subject to estate tax. The result of using a Bypass Trust and the marital deduction is that all federal estate taxes can be avoided in the estate of the first spouse to die, and the property remaining in the Bypass Trust at the surviving spouse's death escapes taxation in her estate. When should the decedent spouse pass marital deduction property to the surviving spouse in trust rather than outright? A trust can provide the following: 1) more control over the ultimate disposition of the property, 2) more flexibility in making beneficiary distributions, 3) protection from trade and judgment creditors, and 4) multiple generation tax minimization. To qualify for the marital deduction the trust must provide that the surviving spouse is entitled to at least the income of the trust for life. The trust can optionally provide the spouse with any amounts over and above the income as desired. The two most common types of marital deduction trusts are the Testamentary QTIP (qualifying terminable interest property) Trust and the Life Estate with Power of Appointment Trust. When it is desirable to prevent a potential diversion of assets from the decedent's family, such as may occur in the case of the surviving spouse's remarriage or children from a previous marriage, a QTIP Trust can be used. In addition to providing the surviving spouse the income from the trust during her life the QTIP Trust can optionally provide her with the greater of $5,000 or 5% of the principal of the trust each year, any additional amounts required for her health, education, maintenance and support, and the power to specify remainder beneficiaries of the trust (except she cannot name her estate or her creditors as beneficiaries). The Power of Appointment Trust, on the other hand, gives the surviving spouse more control over the trust property. This type of marital deduction trust can allow her to specify the ultimate beneficiaries and/or make discretionary distributions (to herself and others) during her life. One advantage of this trust is it allows the surviving spouse to make annual exclusion gifts to children out of trust property to reduce her estate tax exposure. Using a QTIP Trust enables the executor to elect to qualify all or a portion of the trust for the marital deduction. This may be desirable, for example, when the surviving spouse's estate would likely be taxed at a higher marginal estate tax rate if it included the decedent spouse's entire estate over his tax free credit shelter amount. Instead, the executor would elect to have part of the QTIP Trust taxed in the decedent spouse's estate. If it is desirable to remove marital trust income from exposure to taxation in the surviving spouse's estate a disclaimer may be utilized. If a trust naming the surviving spouse and children as beneficiaries is to receive the disclaimed property there are limits on the surviving spouse's ability to retain certain rights in the trust. Lifetime QTIP Trust For estate tax purposes it is desirable to title a married couple's property in such a manner that if either one predeceases the other the deceased spouse can utilized her estate tax exemption and thereby pass that amount of their combined estate free of tax to children. In order to do this the married couple must title property in each person's name. In some cases the breadwinner-spouse may be reluctant to transfer property to his spouse outright for this purpose. This could be due to a concern over a possible divorce or because of the other spouse's financial history. (Generally, however, the divorce issue would only arise where the property being transferred was not already part of the marital estate, as in the case of inherited property or property acquired prior to the marriage which is kept separate from the marital estate.) A Lifetime QTIP Trust can utilize the non-breadwinning spouse's estate tax exemption without giving the spouse complete control over the transferred property. As with a testamentary QTIP Trust the spouse must at least receive the trust income. Generation Skipping Trust Generation skipping transfer taxes apply to transfers which skip a generation, as with transfers to grandchildren. They are in addition to estate taxes. The first $1,100,000 transferred is exempt from generation skipping taxes. Over that amount generation skipping transfers are taxed at the maximum marginal estate tax rate (currently 50%). A Generation Skipping Trust is an irrevocable trust designed to utilize this exemption in a manner which benefits multiple generations. This is accomplished by limiting distributions from the trust based on specified needs or purposes, such as to provide healthcare, education, maintenance or support, or by having an independent cotrustee serve with authority to make additional, discretionary distributions. In Massachusetts, the must terminate within 21 years after the death of the last beneficiary alive at the time the trust commences. If your children are likely to incur estate taxes at death, or are unlikely to need benefits from your estate after your death, the Generation Skipping Trust may be advisable to provide a foundation for the needs of multiple-generation descendants such as for healthcare, education or support. These trusts can permit the trustee to make discretionary distributions to your immediate children if needed. Normally, annual exclusion gifts to grandchildren are not charged against the $1,100,000 generation skip exemption. However, they will be charged against the exemption if the gifts are made in trust unless the trust is solely for the benefit of one grandchild (one trust for each grandchild) and the assets of the trust are included in the grandchild's estate at death. The sooner you transfer to grandchildren the better since post transfer appreciation will not be charged against the exemption if a timely election is made. Crummey Power Trust A Crummey Power Trust is an irrevocable trust designed to qualify contributions as nontaxable annual exclusion gifts while limiting access by the beneficiaries to the trust property. This is done in order to control the amount and timing of distributions to provide for the beneficiaries well being over time. Qualifying annual exclusion gifts to the trust are a multiple of the number of trust beneficiaries, including in some cases contingent remainder beneficiaries (i.e., a $24,000 transfer to a trust with two beneficiaries qualifies as a $12,000 annual exclusion gift to each beneficiary). The trustee should be someone other than the donor or someone under his control. In most circumstances, beneficiaries go along with the donor's plan to have the funds stay in trust, but they must be notified of the gifts and have the right to withdraw the contributions within a limited time period (usually 30 days). After the withdrawal period the terms of the trust determine when any distributions are made to beneficiaries. The Crummey Power Trust can serve as an Irrevocable Life Insurance Trust (see below). 2503(c) Minor's Trust Like the Crummey Power Trust this type of trust is irrevocable, can serve as a receptacle for insurance on the life of the donor, and can qualify for the annual gift tax exclusion (if the trust provides that funds can be used for the minor's benefit if needed). Unlike the Crummey Power Trust, however, the 2503(c) Trust can have only one beneficiary and there is no need to notify the beneficiary of contributions. The assets in the trust must be distributed when the minor reaches 21 unless it provides a limited withdrawal period (commonly 30 to 60 days) upon the minor's 21st birthday, after which amounts not withdrawn can continue to be held in trust. Alternatively, the trustee can purchase an annuity and give it outright to the minor at the age of 21, thus effecting a desired payout over time. The advantages of the 2503(c) Minor's Trust trust are twofold: potentially lower income taxes on family assets and reduced exposure of the donor to gift and estate taxes. An alternative to the 2503(c) Trust is titling the gifts in the name of an adult as custodian of the minor under the Uniform Transfers to Minors Act or similar local law. Although this may be simpler than the 2503(c) trust it is less flexible because it must end, and the funds must be distributed to the minor, when the minor reaches the age of majority. Furthermore, if the custodian is a parent the proceeds would be included in the parent's estate at his death because he could have used the funds to fulfill his own child support obligation. Irrevocable Life Insurance Trust An Irrevocable Life Insurance Trust is a trust that holds life insurance with a death benefit payable on the death of a named individual (usually the donor of the trust). This planning vehicle combines the standard life insurance feature of no-tax on income and appreciation with the benefit of no-estate-tax on payment of death benefits. To achieve the latter feature the trust holding the life insurance must be irrevocable, it cannot be under the control of the donor, and the donor cannot have any incidents of ownership in the policy within three years of his death. The donor typically funds the premium payments paid by the trust with annual exclusion gifts made to the trust. To satisfy the present interest requirement of an annual exclusion gift the trust must provide that beneficiaries have the right to withdraw gifts to the trust for a specified period of time (usually 30 days). The trust language provides that if the gift proceeds are not so withdrawn the power to withdraw lapses. This present interest feature is the basis of a Crummey Power Trust. After the power to withdraw lapses the funds can be used by the trustee to pay premiums. Tax Favored Giving Strategies A donor can currently give $2,000,000 free of transfer taxes. It doesn't matter whether the transfers are made during the donor's life or at his death. The exemption is commonly referred to as the "unified credit", the "applicable exclusion amount" or the "credit shelter amount". An additional exemption is the annual gift tax exclusion. $12,000 ($24,000 for married persons) can be given to each donee per year without being charged against the donor's lifetime unified credit. No reporting of such gifts is required. Unlimited transfer tax free gifts may also be made in the form of direct payments to health care providers and schools, the latter for tuition and fees. If you are likely to incur estate taxes at death it may be advisable to give away more than the annual gift tax exclusion amount (thus using up part of your unified credit). This would exclude subsequent appreciation of the gift property from your estate. Even if a donor uses up his unified credit during his life it may be advantageous to continue gifting over and above the annual gift tax exclusion amount. This is because payment of gift taxes earlier than three years before the donor's death removes the amount of the tax paid from his taxable estate. Annual exclusion gifts can be made in trust to provide advantages for beneficiaries. These may include protection from trade and judgment creditors, transfer tax exposure reduction, avoidance of waste, fund management, and funding for multiple generation special needs and incentives.
William F. Smith
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