A common tax strategy for married couples who have amassed significant financial assets is to create a credit shelter trust (CST) in order to maximize the federal estate tax exemption.
Credit shelter trusts, also known as family, bypass, or AB trusts, hold the assets of each spouse in separate trusts. When one spouse dies, the assets flow through from trust A to the surviving spouse’s trust B. But since each trust is maintained and administered separately, the assets in trust A are not added to the surviving spouse’s estate, which helps affluent couples transfer high-net-worth assets, but remain under the federal estate tax threshold.
Credit shelter trusts also receive a step-up in basis, but there’s a catch. Let’s jump into the basics of CSTs in greater detail.
The potential benefits of setting up a credit shelter trust can reach well beyond tax planning.
CSTs are irrevocable, meaning the trust can’t be altered after its creation. That can be especially important for blended families, or for surviving spouses that go on to remarry and want to protect financial assets from their first marriage. When the first spouse dies and his or her assets are placed within a credit shelter trust, it guarantees that the surviving spouse and paternal children will receive income from the trust, and that the assets under trust will be transferred to the named beneficiaries when the surviving spouse passes. There’s no legal wiggle room for any stepchildren or a new step-parent to challenge the terms of the credit shelter trust.
Another important benefit is the surviving spouse’s ability to draw income from the trust to fund healthcare costs, education, or living expenses. Even though the surviving spouse can tap into trust income, he or she does not have access to the entire trust principal – those funds are held by a designated trustee and are passed to the final trust beneficiaries when the surviving spouse dies.
Lastly, as the name implies, funds in a credit shelter trust are shielded from creditors.
When the credit shelter trust is initially funded upon the death of one spouse, the assets that are placed under the trust receive a step-up in basis. This is an important consideration, because any assets held in a CST don’t receive a second step-up in basis upon the death of the surviving spouse.
If the surviving spouse goes on to live for another decade or longer, and the assets that were placed under trust upon the death of the first spouse realize significant appreciation, the heirs to the trust may face a large capital gains tax liability should they choose to liquidate those assets.
Prior to The Tax Cuts and Jobs Act of 2017, creating a credit shelter trust was an exceptional estate planning tool for wealthy couples because it helped preserve generational wealth while minimizing the burden of federal and state estate taxes. However, with the steep increases to the federal estate tax exemption – $12.06 million in 2022 and $12.92 million in 2023 – most Americans don’t need to take on the additional administrative expenses and annual IRS filings that come with forming CSTs.
Additionally, assets that are placed in a credit shelter trust receive a one-time step-up in basis at the time the trust is funded. There’s no provision for a second step-up in basis when the surviving spouse dies and the trust assets flow to the designated beneficiaries. Heirs could incur significant capital gains taxes should they choose to sell any highly appreciated assets that have been held in the credit shelter trust.
Credit shelter trusts may still make sense for high-net-worth couples. Consulting with an experienced estate planner can help determine which options are best for your particular situation.