If you want your estate plan to provide for a spouse or partner, consider these strategies:
- Trust planning for married couples:
- Credit shelter trust and “portability”
- Qualified terminable interest property trust (QTIP trust)
- Trust planning for unmarried partners, couples in a civil union, or couples in a state-recognized domestic partnership
Keep in mind the examples used in this section focus on federal estate tax law. Several states have state-specific estate taxes that may impact your estate plan. Address state-specific tax issues with your tax and legal advisors to determine if additional planning is needed.
Married couples >
Credit shelter trust planning
A credit shelter trust is a technique that helps married couples whose taxable estate exceeds $5,490,000 in 2017. This type of trust offers three main benefits:
- Protecting the applicable exclusion of the first spouse to die
- Providing funds to the surviving spouse during his or her lifetime
- Allowing assets in the trust to bypass the surviving spouse’s taxable estate
Let’s look at how a credit shelter trust may work in your estate plan.
A married couple can provide for a credit shelter trust in their wills or revocable living trusts. Here’s how it works (see graphic below):
Let’s assume one spouse dies in 2017 when the applicable exclusion amount is $5,490,000. When this occurs, an amount up to the estate tax exclusion is transferred to the credit shelter trust. In some cases, an individual may have an exclusion greater than $5,490,000. This can happen if the individual received additional exclusion amounts from a previously deceased spouse, if a “portability” election (discussed below) was made. No taxes are due on this amount because of the spouse’s applicable exclusion. The remainder of the estate passes to the surviving spouse with no taxes due because of the unlimited marital deduction.
The surviving spouse can receive a lifetime income from the trust. He or she could also have access to the principal according to standards you set in the trust document.
Assets within the credit shelter trust can grow but are not a part of the surviving spouse’s taxable estate.
When the remaining spouse dies, the assets in the trust are distributed to the named beneficiaries according to the trust’s terms. The trust assets will not be included in the second spouse to die’s taxable estate. As a result, he or she still has his or her applicable credit available to offset estate tax that may be due at his or her death. So bottom line, a credit shelter trust lets a married couple transfer up to $10,980,000 to children or other beneficiaries in 2017 with no estate tax liabilities.
But what if a married couple does not have credit shelter trust planning in place?
If you leave all your assets to your spouse, there is no estate tax because of the unlimited marital deduction. However, taxes may still apply at the second death.
Let’s assume that when the second spouse to die passes away the total estate is worth $10,980,000 (see graphic below). The heirs would ordinarily have to pay estate taxes on the portion of the estate that exceeds the deceased’s $5,490,000 applicable exclusion. As a result, the estate taxes due would be $2,196,000. Therefore, the children would receive only $8,784,000 because the applicable exclusion of the first spouse to die was not utilized.
However, the 2012 Taxpayer Relief Act provided relief and allows the deceased spouse's executor to elect to transfer all (or part) of the deceased spouse’s unused estate tax exclusion to the surviving spouse. This process is referred to as making a “portability” election. In effect, portability allows the deceased spouse’s unused exclusion to be transferred to the surviving spouse.
Let’s take a look at an example of how portability could work in an estate plan (see graphic below).
Let’s assume a married couple with a $10,980,000 estate who either did not have credit shelter trust planning in place or was unable to take full advantage of that planning opportunity. One spouse dies, leaving the entire estate to the surviving spouse. The executor of the deceased spouse’s estate can make a portability election. Therefore, when the surviving spouse dies, both exclusions are available to help offset any estate taxes.
Portability is simple and allows for flexibility in maximizing the use of the estate tax exclusions, but it has risks and disadvantages as well:
First, it is available only if affirmatively elected. If the executor of the estate of the first spouse to die does not file the necessary return to make the election, the opportunity is lost.
Second, if you live in a state that imposes its own state-level estate tax, portability will not be effective to transfer any state exclusion.
Third, the transferred exclusion is fixed and does not grow. If the surviving spouse lives for a number of years and the inherited assets grow, any growth would not be protected from estate taxes.
Fourth, the portability election’s benefit can be lost if the surviving spouse remarries and also survives the new spouse. Federal tax law specifies that you can only use the additional exclusion transferred by your most recently deceased spouse. So if you survive more than one spouse, the benefit of the transferred exclusion can be lost.
In contrast, there are several reasons to discuss credit shelter trust planning with your estate planning attorney.
First, any appreciation in the assets that fund the credit shelter trust is not subject to estate taxes upon the surviving spouse’s death.
Second, the first deceased spouse controls who will benefit from the credit shelter trust. This may be important if the spouses’ beneficiaries differ, as often occurs in a second or subsequent marriage.
Third, a credit shelter trust may provide some asset protection to the surviving spouse, depending on state law.
And finally, this is an opportunity to shelter assets from the effects of any future tax-law changes.
If you or your spouse have children from previous marriages, you may intend to leave certain assets to them. You may also want to ensure that your spouse has use of the assets during his or her lifetime. A “qualified terminable interest in property” trust, also known as a QTIP trust, is an irrevocable marital trust commonly used in these circumstances.
Let’s see how a QTIP Trust works (see graphic below).
In this example, Martin and Mary each have been previously married, and they each want their own children from the previous marriage to benefit from their assets. Martin also wants to provide financial security to Mary but wants to be sure that when Mary dies any remaining assets be distributed to his three children – not Mary’s daughter.
To meet this objective as well as accomplish their other estate planning goals, they can include provisions for a QTIP trust in their wills or revocable living trusts. The QTIP trust is often used in conjunction with a credit shelter trust.
Let’s say Martin is the first spouse to die. At that time, his assets in excess of the amount transferred to a credit shelter trust are used to fund a QTIP trust and are not subject to estate taxes because of the unlimited marital deduction. Instead, the potential estate tax liability is deferred until Mary’s death, when the assets are included as part of her estate to calculate the estate tax.
When Mary dies, her assets are distributed to her designated beneficiaries, and the assets from Martin’s QTIP trust and Martin’s credit shelter trust are distributed to his designated beneficiaries. Mary’s assets and the QTIP trust assets may be subject to estate taxes when Mary dies. If the amount of assets in Mary’s estate plus Martin’s QTIP trust exceed the applicable exclusion amount ($5,490,000 per individual in 2017), the beneficiaries will have to pay estate taxes.
Trust planning for unmarried couples >
Trusts can also be used to provide for an unmarried partner. It is important to keep in mind that the $5,490,000 applicable exclusion is a powerful tool that couples can use to avoid or reduce federal estate taxes. Under current law, there is no federal estate tax for an unmarried couple whose combined estate is below the applicable exclusion amount.
For example, Ted has a $1 million estate and Nancy has a $1.2 million estate. Ted wishes to provide for Nancy’s financial security after his death, but they are not married.
If Ted dies and leaves everything to Nancy, there is no federal estate tax because Ted’s estate’s value is less than the $5,490,000 applicable exclusion. Of course, no marital deduction is available because they are not married. But the applicable exclusion is large enough to protect Ted’s entire estate from federal estate tax.
Nancy now has a $2.2 million estate. When she dies, there is again no federal estate tax, because her estate is below the applicable exclusion.
Keep in mind that the federal applicable exclusion is indexed to inflation and is therefore likely to change after 2017. Also, some states impose their own estate or inheritance taxes, which could begin at a lower threshold. So it’s important to work with a qualified tax advisor who knows the rules that apply in your state and can help keep you up-to-date on changing laws.
For couples, providing continuing financial security for a partner is often a primary concern. But you should also think about how you would like your remaining assets to be distributed after the surviving partner dies. For example, let’s say that Ted does not have children of his own but has a close relationship with his brother and has a sister with special needs. Instead of leaving assets outright to Nancy, Ted could direct that some or all of his assets go to a trust, which will pay all its income to Nancy and can make principal available to her if needed. But the trust could also provide that after Nancy’s death, any remaining assets will be distributed to Ted’s brother and a special needs trust for his sister.
But what happens when an unmarried couple’s combined estate is greater than the applicable exclusion?
For example, Charles has a $5 million taxable estate and Maria has $4 million. They are not married.
If Charles dies and simply leaves everything directly to Maria, there is no estate tax at his death because his estate is less than the $5,490,000 exclusion. However, all of the assets become part of Maria’s taxable estate. She is now faced with an estate tax based on the couple’s $9 million in combined assets – but with only her applicable exclusion available. This means her beneficiaries may incur $1,404,000 in estate taxes, leaving them with $7,596,000.
Every couple’s financial situation is unique, so it’s important to work closely with your attorney and CPA to determine what is best in your situation. But for financially successful couples, it is generally a good guiding principle to create an estate plan that will take advantage of both available exclusions, to the extent reasonably possible. Let’s take a look at how that might work.
At the first death, instead of leaving assets directly to a survivor, a trust can be funded using the deceased partner’s assets. The trust can be designed to give the surviving partner a lifetime income. He or she can also have access to principal according to the trust’s terms. This trust not only provides for the surviving partner’s financial security but can also be designed so trust assets will not be included in the surviving partner’s taxable estate. This helps reduce estate taxes on the couple’s combined assets when the surviving partner dies.
As a result, the surviving partner still has his or her entire $5,490,000 applicable exclusion available to reduce estate taxes at his or her death. In this example, the estate tax at the second death would be zero since the surviving partner’s estate is worth less than the applicable exclusion.
Keep in mind that the examples used in this section are focused on federal estate tax law. Several states have their own estate taxes that may impact your estate plan. This can get complicated, so be sure to address state-specific issues with your tax and legal advisors to determine if additional planning is needed in your situation.
Nontax reasons for using trusts >
Let’s also take a minute to consider nontax reasons why individuals choose to leave assets in trust for a spouse, partner, or child, instead of making an outright transfer:
If your beneficiary is a physician, attorney, CPA, or entrepreneur, or might be subject to liability for any other reason, a trust may provide him or her with some additional asset protection benefits.
A trust could also be considered if you want to provide for a spouse’s or partner’s financial security but would like to retain control over how assets are distributed after he or she dies.
Or in some cases, you might want to appoint a trustee who can manage trust property and investments if your spouse or partner is inexperienced in financial matters, not inclined to be involved in management, or simply a busy professional who would benefit from having financial matters delegated to someone else.
Every situation is different, so what’s “best” depends on your specific situation. Your attorney can help educate you about the pros and cons of using trusts.