The need for credit shelter trusts arises from the fact that transfers between spouses are not subject to the Federal estate tax. While this exclusion may provide immediate benefits by allowing the entire estate to pass to the surviving spouse free of any tax, the exclusion can also create a situation that causes the combined estates of both spouses to pay more tax than necessary upon the second spouse’s death.
Credit shelter trusts are designed to maximize use of the deceased’s applicable credit against the Federal estate tax, which would otherwise remain unused and ultimately result in greater taxation of the married couple’s combined estates. The underlying goals are to pass the maximum amount of the combined estates following the second spouse’s death, while also allowing that second spouse to use and benefit from the estate while he or she is still living.
In order to qualify as a credit shelter trust for these purposes, the second spouse must not be able to choose the remainder beneficiaries or exert any influence how the trust property will ultimately be distributed and the second spouse’s rights to the trust property must be within acceptable guidelines that restrict his or her use.
In other words, once the first spouse dies and the credit shelter trust is formed, the instructions created by the first deceased spouse have complete control over the ultimate disposition of all trust property to the second spouse and all trust property that remains when the second spouse dies.
These instructions must be formed prior to death and, obviously, cannot be changed by the first deceased spouse at the time they are to become effective. The applicable exclusion amount can only be used after death, meaning that the deceased cannot know the exact state of his or finances at the time the trust is funded.
Funding Determinations
With these facts in mind, there are two main factors that will determine the method of funding selected by the each spouse. 1) How strongly the spouse wishes to ensure that the chosen remainder beneficiaries receive a portion of his or her estate and 2) How likely the spouse believes that his or her estate will exceed the applicable exclusion amount.
Formulas
Formula instructions are most useful when it is more likely that the first spouse’s estate will exceed the applicable exclusion amount. The credit shelter trust instructions can limit rights to the property in such a way that it is not as accessible to the second spouse while the second spouse has other available means, such as through the separate trust.
These instructions are often used to protect assets for the remainder beneficiaries, while ensuring that the second spouse will have use of those assets if circumstances made it necessary.
The typical formula is drafted to place the maximum amount of the estate into trust that will qualify for use of the applicable credit amount. The basic premise of formula instructions may be stated as, “I, Tom, leave all of my estate to my wife, Katie, following the subtraction of that amount of my estate which is the minimum amount necessary to reduce my Federal estate tax to the lowest number. However, if Katie does not survive my death, I leave all of my estate to my children, Jeanie and Ferris.”
Formula funded credit shelter trusts are less concerned with providing for remainder beneficiaries than fixed dollar amount trusts. However, formula trusts are not necessarily more focused on the second spouse than fixed dollar amount trusts. The main goal of these trusts is ensuring maximum avoidance of the Federal estate tax.
Basically, the first spouse leaves the entire estate to the second spouse, but only after subtracting the full amount of the estate that can take advantage of the applicable exclusion amount. If the applicable exclusion amount is $3,500,000 and the first spouse has an estate of $3,000,000, the most strict formula funded trust will require the entire estate to be placed into the credit shelter trust.
(In practice, formula trusts are most often based upon the use of language that divides the value of estate assets into proportionate shares based upon use of a denominator equal to the total estate value and numerators which are respectively equal to the value of the taxable estate required to take full advantage of the unified credit and the resulting remainder.)
Spousal Disclaimers
A disclaimer is the right of any beneficiary to reject all or any portion of an estate prior to his or her use of that property. Disclaimed property is typically distributed as though the disclaiming beneficiary died before the deceased, which will cause that property to pass to the alternate beneficiaries or next appropriate heirs.
Consider the following: “I, George, leave all of my estate to my wife, Lorraine. However, if Lorraine does not survive my death, I leave the same to my children, Marty, Dave, and Linda.” Following the rules of disclaimer, any estate property that Lorraine disclaims will be passed as though she had predeceased George, which would cause it to be distributed among their children.
However, George’s will may also contain instructions that direct the disposition of any property disclaimed by Lorraine, such that the typical disclaimer trust funding instructions will provide: “If my wife, Lorraine, survives my death for a period of thirty (30) days, and disclaims, in whole or in part, any property or any interest therein, which is otherwise distributable to her by reason of my death, I direct that all such property or interests which are so disclaimed shall be distributed to the hereinafter named Trustee, or any successor, to be held in a separate trust according to the following terms…”
This is the most spouse-protective type of credit shelter trust. As previously noted, the deceased spouse’s instructions for funding and administering the trust cannot be changed once he or she dies. Disclaimer trust instructions allow the second spouse to fully examine the entire set of circumstances surrounding their combined estates at the time of the first spouse’s death. For instance, if the applicable exclusion amount is $3,500,000 and the first spouse has an estate of $3,000,000, the second spouse may choose to disclaim only half of the estate and keep the remainder free of trust.
This freedom also means that the second spouse is not required to disclaim any of the first spouse’s estate and may simply choose to retain all of the property. Once that property belongs to the second spouse, he or she is can give it to any one without restriction.