Credit Shelter Trust/Bypass Trust

WHAT IS IT – WHY IT IS USED - HOW IT FITS IN THE TYPICAL PLAN TO SAVE FEDERAL ESTATE TAX

A Credit Shelter Trust or a Bypass Trust is used to take advantage of one of the principal tax saving provisions under the Federal Estate Tax Law - the "unified credit." In many estates, there are no Federal Estate Taxes because of the availability of the unified credit, either alone or combined with other provisions in the law like the "marital deduction" provision, the "state death tax deduction" provision and provisions that permit other deductions.  If a husband and wife have a combined estate of $1,000,000 or less, they probably do not need to be concerned about a credit shelter trust because even the reduced unified credit in year 2011 will, in most situations, eliminate any Federal Estate Tax.  Married couples with a combined estate in excess of that amount or who expect their estates to grow beyond that amount may wish to consider the substantial tax savings that can be obtained from the use of a credit shelter trust.

Unified Credit

Under the Federal Estate Tax Law, every person is entitled to use a credit against his or her Federal Estate Tax obligation. It is known as the "unified credit." This credit allows each person, upon his or her death, to pass to the person’s heirs a certain dollar value of his or her property, without paying any Federal Estate Tax. The amount of this figure is gradually increasing over the years.  It was $1,500,000 for people who died in 2005. It was $2,000,000 for people who died in 2006, 2007 or 2008.  It increased to $3,500,000 for people who die in 2009 and is scheduled to decrease to $1,000,000 for people who die in 2011 or thereafter. Under current law, there will be no Federal Estate Tax for people who die in 2010.  [There is a separate Article at this Website that contains the annual figures for each year from 2001 to 2011.]

 

Tax Computation - Tentative Tax

When a person dies, the Federal Estate Tax is computed on his or her entire estate. This is called the "tentative estate tax." The person is entitled to a credit equal to the Federal Estate Tax on an estate that was the size of the unified credit amount. In other words, if a person dies in 2009, the person is entitled to a credit equal to the Federal Estate Tax on an estate of $3,500,000. This credit is deducted from the tentative estate tax that was computed. Therefore, at the present time, if the person’s estate is $3,500,000 or less, the credit completely will wipe out the tax. If the estate is more than $3,500,000, the credit will reduce the tax.

Marital Deduction

Another significant provision under the law is the "unlimited marital deduction." This provision allows an unlimited amount of money or other assets to pass from one spouse to another (U.S. citizen) spouse upon the death of one of the spouses, without incurring any Federal Estate Tax obligation. At first, this might seem to be an ideal estate plan – leaving everything to the surviving spouse and paying no Federal Estate Tax. However, a hidden and potentially costly trap lies in this provision. This is because if the combined estates of both spouses are large enough, there will be Federal Estate Tax to pay when the second spouse dies. Depending upon the size of the second spouse’s estate, considerable tax savings could have been achieved by not having all of the couple’s assets pass to the surviving spouse.

How the Credit Shelter Trust Works to Save Taxes

When the surviving spouse dies, he or she is entitled only to a single unified credit. If the surviving spouse's estate (combined with the assets received from the first spouse upon the earlier death) exceeds $3,500,000 in 2009, Federal Estate Taxes will be due and that tax might have been reduced or eliminated by taking advantage of the unified credits of both spouses. The credit shelter trust or bypass trust is designed to do just that. It "shelters" the unified credit by preventing some of the assets from passing to the surviving spouse upon the first death. A portion of the assets of the first spouse to die passes into this trust where the assets will not be subject to Federal Estate Tax in either spouse’s estate.

The terms of the credit shelter trust result in it being potentially subject to tax in the estate of the first spouse to die. However, the terms of the will or living trust that create the credit shelter trust limit the dollar value of the assets passing into the trust to the maximum amount that could pass free of Federal Estate Tax (2009 - $3,500,000). Although those assets were potentially subject to the tax, the unified credit "wipes out" the tax. The rest of the estate passes to the surviving spouse where it receives the benefit of the marital deduction -- no tax. When the surviving spouse dies, he (or she) will receive the benefit from his (or her) own unified credit. The credit shelter trust, therefore, permitted the two spouses to take advantage of two unified credits rather than one.

Examples - Click here for a table with examples of two different estate plans and how the use of a credit shelter trust might reduce or eliminate Federal Estate Taxes.  [example currently being revised]

Warning: This Article, the accompanying Table and their contents are for informational purposes only and do not constitute legal advice. The Table ignores many variables such as the state inheritance tax, the state death tax deduction, possible increased tax due to prior gifts, other available deductions, etc. The particular circumstances may affect a person's tax obligations and tax rates. You should consult an attorney in the state where you reside to determine how the Federal Estate Tax should be calculated in your particular situation and what tax savings might be available from the use of a credit shelter trust before acting on any information contained here.

Notice Pursuant to Final Regulations Under Circular 230, effective June 20, 2005
The opinions contained in any communication on the website are not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer under the Internal Revenue Code.