Common Estate Planning Techniques for a Couple With Children

The following should not be used as a substitute for legal advice since it involves a very technical and changing body of law.

A. Credit Shelter Trust

With this technique, your Will will provide for the creation of a Credit Shelter Trust at the time of your death to receive your estate up to the maximum amount of the federal estate tax credit (Federal Credit). The Federal Credit is the amount of money your estate can transfer to anyone without being subject to Federal estate tax. In 2009, the Federal Credit is $3.5 million reduced by the amount of gifts you made during your life which are allowed up to $1 million. Your Will will designate an individual(s) or an entity to manage the assets placed in the Trust. That individual or entity is commonly called the Trustee. The Trustee will manage the assets according to your instructions specified in your Will. For example, you could instruct your Trustee to use the income of the Trust and, if necessary, the capital to maintain a certain living standard for your spouse for the remainder of his/her life and to distribute the remainder of the trust to your children upon his/her death. Note that the Trustee could also be instructed to keep the assets in the trust after the death of your spouse and to use the income and capital for the benefit of your children. Doing so would prevent the assets of the trust to be included in your children’s estate at the time of their death and could in effect avoid the federal estate tax that would otherwise be imposed at the time of the death of your children. This technique would in effect allow you to avoid the generation skipping tax. See below under Generation Skipping Trust.

Direct benefits of the trust. Your assets will be managed by a competent person, your spouse’s financial needs will be provided for, your assets will be protected from your spouse’s creditors as well as from her potential next spouse, and your children, and possibly grandchildren, will receive your assets free of any federal estate tax. Furthermore, this trust will maximize the combined Federal Credit for you and your spouse if your combined estate is worth more than $3.5 million. For example, assume that your combined estate is worth $7 million and spouse inherits your entire estate in her name at the time of your death. Your spouse’s estate will therefore be $7 million. Assume, further, that at the time of her death her estate is still worth $7 million and she bequeaths all of her estate to your children. At that time, she will use her $3.5 million Federal Credit so that only half of the transfer to your children will be protected from the 45% federal estate tax. The tax liability will be $1.58 million. Had your Will created a Credit Shelter Trust, $3.5 million of your estate would not have been included in her estate at the time of her death and your combined estate would have been transferred to your children without any federal estate tax even if at that time the trust had grown to a much higher value. The Federal Credit is expected to revert on January 1, 2011, to $1million which means that a greater number of couples could receive the tax-saving benefits of a Credit Shelter Trust.

Maryland specificity. Maryland also imposes an estate transfer tax (16% in 2009) for estates above a certain value. Up to 2004, Maryland followed the Federal Credit and imposed its tax only on estates that exceeded the federal limit which would have been $3.5 million in 2009. However, since 2004, the Maryland credit is capped at $1 million. Thus, $2.5 million placed in the Credit Shelter Trust, described above, could be subject to the 16% Maryland estate tax. One possibility to minimize this tax liability is to divide the Credit Shelter Trust into two sub-trusts, one to hold $1 million exempt from both federal and Maryland estate taxes and the second to hold the remainder in a Q-TIP trust so that the Maryland tax will not be assessed until the death of your spouse and based on the value of the remaining assets at that time. (See Q-TIP election below under Marital Trust.) This second sub-trust will still be considered part of your estate for federal estate purposes and will therefore use the full amount of Federal Credit. However, for Maryland purposes this sub-trust will be considered to be part of your spouse’s estate and therefore will be subject to the Maryland estate tax only at the time of his/her death.

Pitfalls/Main requirements: Assets must be allocated so that neither spouse has an estate above the Federal Credit while the other estate is below the Federal Credit. Thus, properties may have to be transferred between spouses either outright or in trust. Note that a surviving spouse can disclaim, within nine months of the death of her/his spouse, the joint property interests held with the right of survivorship. If the surviving spouse is not a U.S. citizen the value of the entire joint properties is included in the deceased’s estate, unless a treaty provides otherwise or a Q-DOT election is timely made. (See Q-DOT below under Marital Trust.) The rights of the surviving spouse in the Credit Shelter Trust must be limited to prevent the IRS to re-qualify the assets as being owned outright and therefore includable in her/his estate. It is generally acceptable to give all of the income to the surviving spouse provided that no more than $5,000 or 5% of the principal can be withdrawn each year. If the surviving spouse is also the trustee, the trustee’s right to distribute income and principal must be limited by an ascertainable standard.

Flexibility. Your Will can provide that all properties shall be transferred outright to your spouse with the right for her/him to disclaim and transfer to a Credit Shelter Trust. This flexibility allows the Credit Shelter Trust to be created by the surviving spouse only if he/she believes it to be necessary considering the size of the combined estates at that time.

B. Marital Trust

The properties in excess of $3.5 million usually go to the surviving spouse either outright or in trust. Doing so postpones the tax liability until the death of the surviving spouse since transfers between spouses are generally not taxed. To qualify as a marital transfer, generally, the property must be transferred outright to the surviving spouse. A Q-TIP trust (Qualified Terminable Interest Property trust) provides an exception to this rule and allows you to control your spouse’s access to the properties without jeopardizing the marital transfer qualification and benefit. Transfers to a Q-TIP trust, rather than outright, would be recommended, like for a Credit Shelter Trust, to implement your testamentary wishes, to provide for your spouse while protecting the interests of your descendants and to minimize the tax liability. The tax saving, in this case, is primarily based on the deferment of the tax until your spouse’s death. Another tax saving can be generated if your executor elects, for the purpose of calculating the Generation Skipping Tax (see below) to treat the transfer as if the Q-TIP trust had not been created. The result of that election (called a Reverse Q-TIP election) will maximize your combined exemptions of Generation Skipping Tax which could save substantial taxes for your grandchildren.

Pitfalls/Requirements. To qualify as a marital trust, the surviving spouse must receive all the income from the trust, the principal may be invaded for her/his support but not necessarily. The remainder of the trust can be distributed according to your instructions but no properties can be distributed to anyone other than your spouse during her/his life. Your executor must elect to have the remainder of the trust included in the estate of your surviving spouse.
The qualification and benefit of Marital Transfer is generally granted only if the surviving spouse is U.S. citizen. If this is not the case, the Marital Trust must qualify as a Qualified Domestic Trust, Q-DOT. One of the main requirements for Q-DOT qualification is to select at least one trustee who is a U.S. citizen. Q-DOT qualification is not necessary if a treaty with your spouse’s country provides marital transfer benefits to its citizens to the same extent as those granted to a U.S. citizen. At the time of this writing such treaty provisions exist with France and England.

Issue of Funding. At the time of your death, your beneficiaries will get a stepped up basis in the properties received from you. The stepped up basis means that, for their own future tax liability, the IRS will treat your beneficiaries as if they had purchased the properties at the value they had at the time of your death. However, any increase in value between the time of your death and the time the property is transferred to the trust will be taxable capital gain if the trust was funded with a pecuniary bequest. Any funding formula that refers to a quantity is considered a pecuniary bequest; for example, “the trust shall be funded with an amount equal to the maximum amount not subject to federal estate tax”. On the other hand, if the trust is funded with a residuary clause such as “my executor shall transfer all of my residuary estate into this trust”, then, any capital gains tax is deferred until the asset is actually sold. Generally, the smaller of the Credit Shelter Trust or the Marital Trust is the pecuniary trust so as to minimize the amount of capital gains tax to be paid at the time of funding.

C. Generation Skipping Trust (GS Trust)

Generally your estate is taxed a second time if the beneficiary of your estate is two generations removed from you. For example, if the remainder of the Credit Shelter Trust is distributed to your grandchildren at the time of your surviving spouse’s death instead of your children, a tax of 45% will be due at that time since the Credit Shelter Trust protects your estate only against the estate tax due at the time of your death. A GS Trust allows the transfer of up to $3.5 million to your grandchildren without any federal estate tax. The executor of your estate must elect GS status at the time of funding the trust. Once the allocation is made, all appreciations in value can also be transferred free of federal estate tax. Thus, if the value of the GS Trust grows to $10 million by the time it is distributed to your grandchildren, the whole amount will be exempt from federal estate tax. The Credit Shelter Trust could be set up as a GS Trust. In this case, you could instruct your trustee that upon the death of your surviving spouse the trust should be split in as many trusts as there are children of yours to be used for their support for the remainder of their lives and then to be distributed to their own children in trust or outright. Usually, the GS election is applied to those assets that have the most probability of appreciation.

D. Irrevocable Life Insurance Trust

Life insurance benefits are usually subject to federal estate tax unless you have not retained any ownership interest in the policy. There are generally two ways to divest ownership in an insurance policy. The first method is to buy a fully funded life insurance and transfer ownership to the beneficiary. If funding fully the insurance is not an option or not desirable, the second option is to set up an irrevocable trust that will hold the insurance policy and into which you will transfer each year an amount sufficient to cover the insurance premium. If the annual premium is below $13,000, as is often the case, each annual transfer to the trust will be an excludable gift if the beneficiary of the trust had been given a 30 day opportunity to withdraw the money. This is commonly called a crummey notice. The beneficiary will rarely elect to take out the money since you, the grantor of the trust, could simply stop funding the trust and the insurance policy would be terminated. For this reason, it is advisable to create a separate Irrevocable Life Insurance Trust for each beneficiary. It is also advisable to transfer an amount that is not exactly the same as the premium amount.
Note that a three year rule applies if the insurance policy is transferred to the trust rather than bought by the trust. Under that rule the insurance proceeds would be included in your estate if you die within three years of setting the trust.