A new provision in federal tax law allows surviving spouses to utilize any unused portion of their deceased spouse’s estate tax exemption — up to $5 million — to reduce their taxable estate.
But this new rule of portability does not diminish the need for clients to establish a credit shelter, or ”A/B,“ trust.
Typically a credit shelter trust (CST) is established to preserve or utilize the estate tax exemption upon the death of the first spouse. Generally, the CST would be funded up to the maximum current estate tax exemption. Assets in the trust are divided in a way that both spouses may use their full exemption.
The new portability provision may also maximize the use of the estate tax exemption. However, the provision only applies to estates in 2011 and 2012, and there is no guarantee that it will be available in the future. Also, the surviving spouse must elect to use the portability provision, as it is not automatic.
In addition, there are other advantages of a CST that are not part of the portability rule.
The portability provision does not provide a tax shelter for the appreciation of assets that may have accrued in the estate from the death of the first spouse to the second spouse. Consider this example of how a trust can also protect the appreciation of assets following the death of the first spouse:
- Assume an estate valued at $10 million at the time of the death of the husband in 2011
- The surviving wife passes away the following year in 2012
Utilizing the portability provision, $10 million of assets can be sheltered from estate taxes upon the death of the wife. However, if a credit shelter trust was established and funded with the $5 million exemption amount at the death of the husband, appreciation on the assets within the trust would also be sheltered from estate taxes. Assuming the assets inside the trust grew by 8% during the year between the death of the husband and the death of the his spouse, an additional $400,000 worth of assets (8% of $5 million) would have been sheltered from the estate tax utilizing the trust strategy. Assuming a 35% estate tax rate, this results in direct estate tax savings of $140,000 (35% of $400,000).
CSTs may also offer protection from creditors. If established properly, the future creditors of the surviving spouse or creditors of beneficiary children will not be able to access the assets of the trust.
While the new portability provision may serve as a ”safety net“ for families that failed to plan properly, a well-structured CST is still a viable estate planning vehicle.