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What Is a Credit Shelter Trust?

By John Maxfield – Updated Oct 5, 2018 at 1:55PM

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A credit shelter trust allows a married couple with a sizable combined estate to take full advantage of estate tax exemptions.

A credit shelter trust is a type of trust fund that allows married couples to reduce estate taxes by taking full advantage of state and federal estate tax exemptions. As such, it's generally only applicable in cases of multimillion-dollar estates.

Let's say, for example, that Bob and Mary Jane have been married for many decades and have each accumulated estates worth $4 million. Bob then dies, leaving Mary Jane the entirety of his $4 million estate, boosting her net worth to $8 million. While Bob's estate would be free from federal estate taxes, as the current federal estate tax exemption is $5.43 million, Mary Jane won't be as fortunate. When she passes away, and assuming her $8 million estate has been preserved, her estate will exceed the exemption threshold by $2.57 million. It's this potential issue that credit shelter trusts are designed to remedy.

Man in suit holding out a nest with a golden egg in it

Image source: Getty Images.

Generally speaking, a credit shelter trust is no different than any other type of trust. One is created when a person, the "settlor," transfers money or property into the hands of a trustee, who agrees to administer the trust on behalf of a designated beneficiary. What's critical is the transfer itself, as the conveyance removes the money and/or property from the settlor's estate for the purpose of probate and estate taxes. Additionally, per our example above, because the money and/or property is handed over to the trustee, it similarly doesn't become a part of the surviving spouse's estate.

What's unique about a credit shelter trust is its narrowly defined purpose, as well as the identities of the settlor and the primary beneficiary. While the latter are husband and wife, their role depends on which spouse dies first. If the husband dies first, as often happens given the difference in life expectancy between men and women, then he's the settlor and his wife is the beneficiary. If the wife dies first, then the roles are reversed. Either way, the purpose of the trust is to give the surviving spouse access to the income from the transferred property without adding it to his or her estate and thereby potentially pushing the combined amount over the federal estate tax exemption.

To see how this works in operation, let's return to our example of Bob and Mary Jane. This time, however, based on the recommendation of a tax attorney, Bob sets up a credit shelter trust that, upon his death, is immediately funded with his $4 million share of their combined estate. The trust effectively gives Mary Jane a life estate to use the trust assets and benefit from any income therefrom; upon her death, she's replaced as the beneficiary by their two children, Becky and Dave. As before, Bob's estate would be free from federal estate taxes because it's below the $5.43 million exemption threshold. But unlike before, Mary Jane's estate would also be free from federal estate taxes, as she never actually took control of Bob's estate. Consequently, while she would have full access to Bob's assets after he passes away, her estate would be valued at only $4 million as well.

In short, credit shelter trusts are great ways for a married couple with a sizable combined estate to take full advantage of estate tax exemptions without requiring the surviving spouse to relinquish his or her rights to the deceased spouse's share of their combined grubstake. If you're in this situation, it might behoove you to speak to an attorney about this innovative way to reduce estate taxes.

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