Credit Shelter Trust
A Credit Shelter Trust (also referred to as a bypass trust, "B" Trust, or a family trust) is a popular estate planning tool traditionally used to help protect assets from successive estate taxes. Credit Shelter Trust provisions may be inserted into a Will or into a Revocable Living Trust. While current laws permit an unlimited amount of assets and property to pass to a surviving spouse tax free, transfers to children and other beneficiaries valued in excess of the applicable exclusion amount ($5.25M in 2013) may be subject to federal estate taxes (given that Congress could repeal the current tax laws in the future). A couple taking advantage of a credit shelter trust generally arranges for certain assets to pass into a trust for the benefit of a surviving spouse, rather than passing all assets directly to the spouse. This trust, which would not be considered part of the surviving spouse's estate, may pay the surviving spouse income for life and then upon his or her death may pass to a beneficiary, such as a child, free of estate taxes if under the applicable exclusion amount (with the appreciation of the trust assets also passing tax free). In addition, the gross estate of the surviving spouse, upon his or her death, could also pass to the same beneficiary, and up to $5.25M would be free of estate taxes.
PLEASE NOTE: The American Taxpayer Relief Act of 2012 made the $5.25M Federal Estate Tax Exemption Permanent (indexed for inflation in future years). The tax rate for estates above $10.5M is a flat rate of 40%. Furthermore, the Act allows a surviving spouse to add to their deceased spouses exemption amount to their own exemption (which is called "portability"). Portability, in some cases, eliminates the need for complex estate planning (i.e., the use of Credit Shelter Trust language in the estate planning documents) designed to bypass federal estate taxes, which was commonplace prior to the new law. Under the old federal estate tax laws, the exemptions were not portable, meaning that the first exemption was lost without proper estate planning through the use of Credit Shelter Trusts.
Using a Credit Shelter Trust as described below still has great estate planning benefits despite the addition of portability into the federal estate tax regime including:
1. Although the estate tax law changes were made permanent, nothing is ever really permanent in Washington, DC. Therefore, larger estates may still want to include discretionary Credit Shelter Trust language in their documents so that their estate planning is flexible enough to deal with estate tax changes that may occur in the future.
2. There are several non-tax benefits of a Credit Shelter Trust, including: asset protection, professional management of assets, and preservation of assets for children.
The entire value of an estate passing to a surviving spouse receives a marital deduction from estate taxes if the surviving spouse is a U.S. citizen and if the property passing to the surviving spouse is not a "terminable interest". If the property passes to the surviving spouse as a terminable interest, then the transfer does not qualify for the marital deduction unless technical requirements are met. A terminable interest is an interest which will terminate or fail on the lapse of time or the occurrence or failure to occur of a contingency. An interest which passes from the decedent to any other person other than their surviving spouse and such other person enjoys the interest after the termination of the spouses interest, is a terminable interest. For example, leaving property to a surviving spouse which terminates if the spouse remarries is a terminable interest. An exception to the terminable interest rules is a Qualified Terminable Interest Trust (QTIP). A QTIP Trust provision included in a will or revocable trust based plan allows the testator to leave property for the benefit of the surviving spouse during their lifetime while maintaining control over where the property goes after the surviving spouse's death. If properly drafted, a QTIP election will be made by the decedent's personal representative and the QTIP will qualify for the estate tax marital deduction. The following technical rules apply: 1) the surviving spouse must receive all of the income from the trust during their lifetime, payable at least annually; 2) no person including the spouse can appoint the income to anyone other than the spouse during the spouse's lifetime; 3) the QTIP property is included in the surviving spouses taxable estate when they die; 4) QTIP treatment must be elected by the executor of the estate upon the testator's death. A QTIP trust can be a good option where spouses are in a second or third marriage. For example, the surviving spouse is provided with income from the trust for life and when they die the first spouse's children from their first marriage receive the remainder of the trust. If the first spouse is concerned that their surviving spouse could disinherit their children, then a QTIP trust can be useful. This type of trust offers many advantages, however, the testator should keep in mind that the surviving spouse looses control over the assets placed into the trust (though they are still entitled to income from the trust) which could be problematic if the surviving spouse will need the property outright for standard of living and cash flow purposes. Additionally, the surviving spouse is more likely to exercise their spousal elective share rights before the QTIP trust is created.
Irrevocable Life Insurance Trust (ILIT)
An ILIT is a common estate planning tool for wealthy clients. Typically, the proceeds from any life insurance policy owned by you are included in your estate for estate tax purposes (though they are not part of your "probate" estate). An Irrevocable Life Insurance Trust, commonly called an ILIT, is a unique legal document which helps keep the proceeds of a life insurance policy outside of the estate and thus potentially free of estate tax and income tax. The ILIT is a legal entity that becomes operational while one is still living. The trust becomes the owner of the life insurance previously owned or of a new policy purchased in the trust's name. Because the policy is owned by this legally independent trust, you would not be the legal owner of the proceeds, which therefore are not included in your taxable estate. Below are some of the potential advantages and disadvantages of using an ILIT:
1. Removes life insurance proceeds from your taxable estate
2. Provides tax-free liquidity to your estate
3. Preserves real estate, family business or other illiquid assets
4. Uses life insurance proceeds in coordination with charitable gifting in order to replace assets given to a charity
5. Increases the size of an estate
6. Maximizes inheritance while minimizing taxes paid to the federal government
1. ILIT's can be somewhat costly to create and maintain. Costs include attorney's fees for drafting the trust, and annual professional trustee fees charged for drafting the required Crummey letters to the beneficiaries, paying the insurance premiums, and acting as trustee.
2. Transferring funds to the trustee to pay the insurance premiums could take up your entire annual federal gift tax exclusion of $14,000 per individual which limits other gift giving ability.
3. If you are transferring an existing life insurance policy into an ILIT and die within 3 years of the transfer, the death benefit funds from the policy will be included in your taxable estate.
4. Permanence and Loss of Control: the assets are no longer the owners once they place them in the ILIT, furthermore the trust is irrevocable.
There are two ways to establish and fund an ILIT. The first, and best, way
to do this is by establishing the ILIT first, and then allowing the ILIT to
purchase the life insurance. The second method is by establishing an ILIT and
contributing an existing life insurance policy to the ILIT.
Establishing the ILIT first is preferable, because doing so will allow you to avoid any gift tax on the initial funding of the trust. Also, when existing insurance policies are transferred into an ILIT the benefits will be included in your taxable estate if you die within three (3) years of the transfer. You, as the Settlor, make contributions to the ILIT. The trustee then takes the contributions and uses them to pay the premiums on the life insurance policy. In order to avoid gift tax on the contribution to the ILIT, the trust agreement must be properly drafted, and several technical steps must be followed. The policy premiums are typically paid by the Settlor in a manner that avoids gift taxes by use of the annual gift tax exclusion (currently $14,000 per year).
If you have an existing policy, you may establish your Irrevocable Life Insurance Trust and contribute the existing policy to the ILIT. Doing so will result in a taxable gift, although you may use part of your lifetime gift tax credit (currently $5.25 million in 2013) to avoid paying any gift tax on the transfer. The amount of the gift will depend on whether it is a term or whole life policy.
Upon your death, the trustee of the ILIT files the claim for the death benefits. The insurance company issues the check to the ILIT, and the policy proceeds are excluded from your gross estate. The terms of the ILIT should allow the trustee to make loans to, or purchase assets from, your estate. This provides liquidity to the estate for payment of any estate taxes, and prevents a forced sale of assets which may be illiquid or your heirs do not wish to sell.
Example: John has an estate which totals $10.25 million, of which $5M is a death benefit in a large life insurance policy. He will not owe any federal estate taxes on $5.25M under the 2013 Applicable Exclusion Amount, but he will be taxed on the remaining $5M. Therefore, $5 million of his estate will be subject to Federal Death Tax at a 40% rate (i.e., $2M in taxes). John could avoid paying any Federal Estate taxes by transferring the insurance policy into an Irrevocable Life Insurance Trust. Upon his death, the trust, as the owner and beneficiary of the policy, will collect the life insurance death benefit proceeds from the insurance company and distribute them to the named beneficiary. In this scenario, John's estate would be able to avoid paying $2M in taxes and this money could be used to benefit one of his family members, a friend, or a charitable organization instead of the federal goverment.
Charitable Remainder Trust (CRT)
A charitable remainder trust can be a highly effective financial and estate planning tool. This irrevocable trust provides an income stream to the donor or to other non-charitable beneficiaries for life or for a term of years and pays the remainder interest in the trust to one or more qualified charitable organizations. A CRT can be either inter vivos or testamentary in nature, but typically they are created inter vivos (during the donor's lifetime). An inter vivos CRT is created by a written irrevocable trust agreement executed by the donor and the trustee during the donor's lifetime. A testamentary CRT is created by the donors will or revocable living trust. The advantages of a CRT are as follows: 1) allows the grantor to avoid capital gains taxes on highly appreciated assets; 2) donor or donor's beneficiaries receive an income stream based on the full, fair market value (FMV) of those assets; 3) donor is able to claim an immediate charitable deduction on his or her income tax return; 4) the contributed assets are removed from the donor's estate, so there is no estate tax liability on such assets and the donors lifetime unified estate/gift tax exemption is not reduced as a result of making the gift; and 5) the trust assets ultimately benefit the charity(ies) chosen by the donor. There are two primary types of charitable remainder trusts- charitable remainder annuity trusts (CRAT's) and charitable remainder unitrusts (CRUT's).
Charitable Remainder Annuity Trust (CRAT) - The annuity trust pays a fixed dollar amount to the donor or other non charitable beneficiaries each year, regardless of how the value of the trust may change. The fixed dollar amount is based upon a fixed percentage of the initial value of the trust property. An annuity trust may last for a term of years (not to exceed 20) or for the lifetime of the income beneficiary. The income payout from a CRAT to the donor must be at least 5% but no more than 50% of the initial value of the assets transferred to the CRAT. The CRAT has one basic form - a fixed dollar amount.
Charitable Remainder Unitrust (CRUT) - The unitrust pays the donor or other non charitable beneficiaries a fixed percentage of the value of the trust property as is revalued each year. Also, unlike an annuity trust which may not accept further contributions beyond the initial funding, additional contributions may be made to a unitrust (assuming it is created inter vivos). The income payout from a CRUT to the donor must be at least 5% of the annual value of the assets in the CRUT. The CRUT has 4 configurations:
(a) The standard fixed percentage CRUT pays a fixed percentage of the value of the trust assets, revalued annually.
(b) The net income CRUT pays the fixed percentage, or all of the income earned, whichever is less.
(c) The NIMCRUT pays the fixed percentage, or all of the earned income, whichever is less, with a make-up provision which allows payment shortfalls in early years to be made up in later years. The NIMCRUT is the most flexible of the 4 CRUT configurations.
(d) The flip CRUT first pays the fixed percentage, or all of the income earned, whichever is less, and then upon the occurrence of a specified event, flips or changes to a standard fixed percentage CRUT.
A charitable trust may be funded with a gift of cash, securities, real property or closely held business interests.
Lead Trust (CLT)
A Charitable Lead Trust provides an income stream to one or more qualified charitable organizations for the life of a natural person or for a term of years with the remainder interest being paid to the donor or other non charitable beneficiaries. A CLT is primarily used by individuals who wish to benefit a charity first, with the property ultimately passing to family members at reduced tax rates. A CLT is an irrevocable trust which may be an annuity trust or a unitrust. A CLAT pays the charity a fixed dollar amount based upon a fixed percentage of the initial value of the property. A CLUT pays the charity a fixed percentage of the value of the trust property as is revalued each year. The donor may make additional contributions to the CLUT but not to the CLAT. A Charitable Lead Trust is particualarly attractive in low interests environments (such as our current economic situation in 2013) due to its significant tax advantages.
Typically the answer in Colorado
is no. Some planners assert that everyone should have a living
trust, while others believe that a will is all most people need. Before you
make a decision, you should keep a few things in mind. First, the probate process in Colorado
is relatively fast, relatively inexpensive, and is mostly private. Secondly, the creation and maintenance
of a living trust can be more costly than creating a will (typically 2 to 4 times
the cost to create a Will based estate plan), although the cost of probate will
likely be avoided with a living trust.
There are several situations where a living trust could be the proper
estate planning tool, including: 1. You
want to avoid the probate process altogether. 2. You
own real property in more than one state and you want to avoid ancillary
probate (property not owned in trust in other states will need to go through
the probate process in that state in order for title to pass according to your
will; although ancillary probate is often a fairly inexpensive and
expedited probate process). 3. You
want your assets to transfer automatically upon death, avoiding the delays of
the probate court (average probate in Colorado last about 6 months, however,
challenges by the estates creditors are only available for 4 months when an estate
goes through probate).
know that you will be moving to another state in the near future and you want
to make sure that your primary estate planning document is effective in other
states as well. Wills are state specific documents and there is a chance that a
will might not meet the execution formalities required in the new state (although
if a will is validly created in the old state, it is generally accepted in the
new state). However, the trust is not subject to the same formality
requirements of a will and offers mobility advantages to its grantor.
1. You want to avoid the probate process altogether.
2. You own real property in more than one state and you want to avoid ancillary probate (property not owned in trust in other states will need to go through the probate process in that state in order for title to pass according to your will; although ancillary probate is often a fairly inexpensive and expedited probate process).
3. You want your assets to transfer automatically upon death, avoiding the delays of the probate court (average probate in Colorado last about 6 months, however, challenges by the estates creditors are only available for 4 months when an estate goes through probate).
4. You know that you will be moving to another state in the near future and you want to make sure that your primary estate planning document is effective in other states as well. Wills are state specific documents and there is a chance that a will might not meet the execution formalities required in the new state (although if a will is validly created in the old state, it is generally accepted in the new state). However, the trust is not subject to the same formality requirements of a will and offers mobility advantages to its grantor.For the large majority of people in Colorado, a Will based plan is the most economical and efficient choice for their estate planning needs. However, in the right situation, the Revocable Trust can be a great estate planning tool.
While it is true that life insurance proceeds are not taxed as income, the proceeds of an insurance policy may be included in your gross estate for federal estate tax purposes. If you possess what the IRS terms "incidents of ownership" of the policy, the proceeds will be included in your gross estate and taxed accordingly. You possess any of these "incidents of ownership" if you are the owner of the policy, have the ability to change the policy's beneficiaries, can surrender, assign, or cancel the policy, borrow cash, surrender value, or otherwise pledge the policy, or if you own a majority of a corporation which is the owner of the policy. This list is not all-inclusive, but simply illustrates that simply purchasing a life insurance policy will not necessarily provide tax-free benefits to your heirs. Proper drafting, funding, and administration of an Irrevocable Life Insurance Trust will allow the full face value of the policy to benefit your heirs.
This is not recommended. Being the trustee of your own ILIT will cause the proceeds of the policy to be included in your gross estate. You also should not choose your spouse as the trustee if the trust is funded with a second to die life insurance policy. A trusted family member, accountant, attorney, or financial institution may be good choices as trustee of your ILIT.
The choice of a trustee is extremely important. The trustee owes beneficiaries a fiduciary duty to act in their best interests and usually receives compensation for trust management activities, so the grantor usually wants to make this decision personally. Many grantors choose family members or close friends due to personal confidence in those individuals, but others prefer professional trustee institutions (such as attorneys, trust companies, banks, or CPA’s) because of staff expertise. A grantor should consider the burden posed by the trust's administration, the compensation required by a trustee, and the particular needs of the trust. If a trustee is not specified in the trust document, then a court will appoint one, possibly choosing a trustee the grantor would not have chosen freely. Legally, it is not necessary to notify the trustee prior to creating a trust, but a trustee may decline his or her appointment. Therefore, the grantor should choose someone who is willing to take on the required responsibilities, and should inform them of their appointment. It is advisable to choose an alternate trustee in the event the original choice is unable or unwilling to accept the trust obligations when the trust commences. Grantors may choose multiple trustees to act together in managing trusts. Co-trustees must act unanimously unless the trust expressly allows division of responsibilities. A grantor may name himself or herself as trustee during his or her life. Additionally, a grantor may name one of the trust's beneficiaries as a trustee. The only impermissible combination is naming the same person as sole trustee and sole beneficiary, because this arrangement merges the legal ownership with the property benefits as in regular property ownership.
The trustee has several major duties, including:
Loyalty: The greatest duty is for the trustee to be loyal to the beneficiaries. The trustee must administer the trust solely for the benefit of the beneficiaries, and provide full disclosure of his or her dealings. The trustee must deal fairly with the beneficiaries, and not manage the trust to profit his or her own financial interests (i.e., by buying stock in a company the trustee owns).
Administration: The trustee has a positive obligation to do what is necessary for the good of the trust.
Productivity: If the purpose of the trust is to maximize assets over time, the trustee owes a duty to make productive investments.
Earmark: The trustee must keep trust assets separate from all other assets, including those of the trustee, and must clearly identify those assets belonging to the trust in all dealings.
Account: The trustee must provide financial statements regarding the state of the trust.
Nondelegation: Because the trustee holds legal title, only the trustee may manage the trust. However, the trustee may delegate the investment functions of the trust.
Diversification: If the trust involves investment of assets, the trustee must diversify the trust's holdings as a prudent investor would do with his or her own money.
Impartiality: The trustee must act for the benefit of the trust as a whole, and not favor one beneficiary's interests over another's.