Affluent couples with large estates may choose to set up credit shelter trusts in an attempt to preserve generational wealth and pass high-net-worth assets onto their heirs without having to pay estate taxes.
This type of trust can also help heirs avoid the time and expense of probate while ensuring the decedents’ wishes are carried out. Let’s take a closer look at how credit shelter trusts (CSTs) work and how they can be a useful estate planning tool for wealthy couples.
Credit shelter trusts are irrevocable trusts that are created when one married spouse dies. The trust is funded with the entirety or a portion of the decedent’s estate, and assets held within the trust begin flowing to the living spouse. The trust remains under the management of a designated trustee, though, so the spouse never actually takes possession of assets in the trust. This arrangement ensures that there’s no transfer of wealth to the living spouse, yet the surviving spouse still can access income and principal from the trust in special circumstances, such as paying for medical expenses, funding children’s education, or living expenses.
A key benefit of a credit shelter trust is that assets held within the trust are passed tax-free to beneficiaries when the remaining spouse dies. That’s why a credit shelter trust is also known as an AB or bypass trust – spouse A and spouse B have separate estates, and assets within each trust bypass estate taxes when transferred to heirs.
Credit shelter trusts can help affluent couples maximize the federal estate tax exemption, which was $12.06 million in 2022 and jumps to $12.92 million in 2023. The exemption, which is doubled for married couples, is set to drop down to $5 million starting in 2026 when provisions from the Tax Cut and Jobs Act of 2017 are set to expire. In order to maximize estate tax exclusion benefits, spouses should include assets under trust that meet these exemptions amounts.
Here’s an example of how couples can take advantage of the credit shelter trust structure to preserve generational wealth:
A husband and wife own various real property holdings, and over time each amassed an $8 million estate. The wife funds a credit shelter trust with her $8 million, and when she dies her estate passes tax free to the husband since it’s under the federal estate tax exemption. Although the husband now has an estate worth $16 million, placing it well above the estate tax exclusion, the assets in the wife’s credit shelter trust remain outside of his control and under management of a trustee. The husband never actually takes possession of the assets, so his estate is still valued at $8 million. When the husband dies, though, the $16 million estate would be subject to estate taxes since it’s above the federal exclusion.
Another important benefit of a credit shelter trust is the one-time step-up in basis when the CST is first funded. In the example above, the real estate assets held by the wife receive a step-up in basis when placed under trust, which could eliminate any potential capital gains taxes on highly appreciated assets. However, there is no provision for an additional step-up in basis when the surviving spouse dies and the estate is transferred to his heirs.
Credit shelter trusts can be used by affluent couples to maximize allowable federal estate tax exemptions. When using this strategy, each spouse creates a separate trust, and when one spouse dies his or her assets are placed in the bypass trust. The surviving spouse can draw income from the bypass trust, and upon his or her death, both trusts flow to designated beneficiaries.
Since the current estate tax exemption is north of $12 million, CSTs should only be used by married couples with individual estates that are well above this threshold. Establishing a credit shelter trust can be complicated and requires specific language in the formation of the trust, so couples considering this option should engage the services of certified estate planners who have experience creating CSTs.