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.
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.
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.”