The use of a credit shelter or bypass trust, especially in older Wills, and especially in second marriage situations, can have devastating consequences under more recent tax laws if your Will has not bee updated.
There have been substantial changes in the estate and gift tax laws since 1997, and particularly in the last 5 years. These changes may result in extreme 'bad' consequences under estate planning documents, such as Last Wills and Testaments, that were drafted prior to 2010.
If you have a Last Will and Testament that was executed prior to 2010, it may be essential that you have it reviewed. Otherwise, you may suffer some results that were very much unintended at the time you drafted the Will. And for those individuals who are in second marriages, often times the result can be as extreme as completely disinheriting the surviving spouse at the death of the first spouse!
How it works
Here is a quick primer if your eyes are already glazing over or if this is already sounding like piglatin to you: Each person has an amount of assets that they may pass upon death to someone other than their spouse (ie, children, grandchildren, etc.) without incurring a transfer (estate or gift) tax. This amount has been known as the unified credit, or exemption equivalent, or just your estate tax exemption amount. Transfers in excess of this amount incur gift or estate tax upon the transfer. In addition to this amount, there is what is known as an unlimited marital deduction.
How the tax laws have changed
"Traditional" estate planning in the late 1990s up through about 2010 for a husband and wife with a moderate net worth of $1,000,000 to $5,000,000 would generally involve a Will that created one or two trusts. The first is what is known as the "credit shelter" or "bypass" trust. This trust would be funded with the credit or exemption amount. The assets in excess of this amount would generally pass outright to the spouse, or into a second trust, known as a martial trust.
The credit amount was as small as $600,000 as recently as 1997. It gradually increased to $1,000,000 in 2002, then $2,000,000 in 2006, and then $3,500,000 in 2009.
Key among the most recent changes since 2009 is that the exemption amount increased to $5,000,000 and was indexed for inflation (currently $5,450,000 per spouse in 2016) and we now have what is known as "portability" of that credit between spouses.
So what's the problem?
So what's the big deal? These sound like great changes, right? While these changes provide much greater planning opportunities, they can also result in incredibly negative consequences under certain older Wills, depending on how they were structured.
By way of example, let's assume John and Jane Doe had their estate planning last updated 10 years ago, in 2006, when the exemption amount was $2,000,000. Let's assume their net worth at the time was $3,500,000, was primarily in the wife's name, that it was a second marriage for both, and that both had children from prior marriages. Let's further assume that their current net worth has increased to $5,000,000. At the time, in 2006, a common estate plan would have been for Jane's Will to create a credit shelter trust for the exemption amount, which was then $2,000,000. Not infrequently, this trust might have only benefitted Jane's children, and the balance of her assets would have gone outright or in trust for her husband, leaving $1,500,000 to provide for his needs. So what happens when Jane dies on Thanksgiving in 2016 with this Will still in place?
Well, since the exemption amount is now $5,450,000, and assuming the bypass/credit shelter trust created in her Will used a formula provision (which it very likely did), then at Jane's death, the first $5,450,000 goes into this trust for her children. In other words, ALL of her assets. Meaning she has left no assets for her husband, whether outright or in trust. Poor John has, effectively, been completely disinherited.
Even where the credit shelter trust did not exclude the spouse entirely, it often only gave the surviving spouse the income, with no right to encroach on principal. The logic here was there were sufficient other assets (in our example, $1,500,000) to provide for the spouse, so we wanted the credit shelter trust to achieve maximum growth to pass on to the children.
Separate from this issue, for many estates that are in the $3,000,000 to $10,000,000 range, we might not even want to use a credit shelter trust under the current estate tax laws. The benefit of such a trust is that whatever the assets grow to are not taxed at distribution. The cost or detriment of a credit shelter trust is a lower basis in inherited assets. For example, if decedent creates a credit shelter trust with $2,000,000, and it stays in trust for 15 years and grows to $5,000,000, then the $5,000,000 is paid out with no further transfer tax; however, there is $3,000,000 of capital gain exposure built in to be recognized on the subsequent sale of those assets. Under the current tax regime, for estates that are not anticipated to exceed $11,000,000 collectively between a husband and wife, we might likely not even use a credit shelter trust, in order to get a second step up in the basis of the assets at the death the second spouse, thus eliminating the potential for capital gain taxation on the $3,000,000 subsequent appreciation.
These are but a few of the most common "bad results" that can happen under older Wills. Take a few minutes to review your own document, and meet with an estate planning attorney.
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