Estate tax laws have changed significantly in recent years, leading many to question whether trusts are an outdated way to transfer wealth. After all, the Tax Cuts and Jobs Act that passed at the end of 2017 (the “2017 Tax Act”) doubled the estate tax exemption to $11.2 million per person. This followed other significant changes established by the American Taxpayer Relief Act of 2012 (the “2012 Tax Act”) — including “portability,” which allows a surviving spouse to utilize the portion of the federal estate tax exemption that a deceased spouse may not have carved out in his or her own estate documents.
Even with these changes in place, trusts still may play a critical role, both for taxable estates and for those estates under the taxable threshold.
Nontax benefits of trusts
Once considered as onerous structures useful only for the very wealthy, trusts may offer many potential nontax benefits to consider, including:
Asset protection. Protecting inherited assets can become an issue for the beneficiary, especially if a judgment is issued against him or her in a lawsuit. One way to provide some form of creditor protection for those assets is by using a trust. For example, assets left outright to a child or spouse can become commingled with his or her own assets, and those assets can be used to satisfy a judgment against that beneficiary. In contrast, trusts can provide a form of creditor protection for inherited assets because assets held in a discretionary trust are much more difficult for a creditor to access to satisfy a claim.
Marital property protection. Trusts also may be used to protect assets from a beneficiary’s future spouse if the beneficiary later divorces or passes away. Assets held in trust for your spouse can be restricted so that your spouse cannot redirect those assets to a new spouse or children from a new marriage. Trusts for the benefit of your children also can be structured so that assets are available for your children’s needs while protecting them in case your child divorces and/or wants to redirect the assets away from your grandchildren or further descendants.
A suitable management structure for inherited assets. In some cases, you may have concerns about a child’s or spouse’s ability to manage money for his or her own benefit. In addition to including specific instructions in the trust for how it will provide for their needs, you have the option to name an independent trustee to act either as sole trustee or as joint trustee with the beneficiary. Or you can instead provide that your child or your spouse will act as sole trustee of their own trust.
Potential estate tax benefits
Both the 2012 Tax Act and the 2017 Tax Act significantly changed the tax-planning landscape, particularly for wealthy married couples.
Changes to the estate tax, gift tax, and generation-skipping transfer (GST) tax
Under the 2012 Tax Act, the marginal estate, gift, and GST tax rates were set at 40 percent. The tax exclusion was set at $5 million per individual, indexed for inflation ($5.49 million in 2017).
The 2017 Tax Act doubled the exclusion for the estate tax, gift tax, and GST tax — meaning the applicable exclusion increases to $11.2 million per individual, effective in 2018. This exclusion will continue to be adjusted for inflation in future years.
As mentioned above, the 2012 Tax Act enacted portability, which allows the unused unified credit of a deceased spouse to be “ported” or transferred to the surviving spouse, as long as the appropriate election is made on Form 706 (PDF) when the tax return is filed for the estate.
Before the enactment of portability, the unified credit was strictly “use it or lose it.” In other words, your unified credit had to be used at your death because it could not be transferred to your spouse for use at their death. Because of this, many estate plans involved the creation of a credit shelter trust that included the deceased spouse’s unified credit. With the passage of portability, some individuals have foregone the use of credit shelter trusts, instead turning to streamlined portability planning.
Now that the unified credit has doubled, portability may be more widely used. However, credit shelter trusts may serve two important tax-planning functions that may make the extra effort worthwhile1:
1. Shield appreciated assets from further taxation. Funding a credit shelter trust not only helps to shield those assets from estate tax but also may avoid federal estate taxation on the appreciation of those assets.
For example, let’s assume at the husband’s death that the credit shelter trust is funded with $10 million, representing his unused federal unified credit. When his wife dies years later, the assets in the credit shelter trust are now worth $20 million. At her death, the wife also has $10 million in assets held outside the credit shelter trust.
The $20 million in the credit shelter trust, if administered within certain guidelines, is not subject to federal estate tax at the wife’s death, and her own unified credit shields the remaining $10 million from federal estate tax on her estate.
If portability had been used instead, the wife would have been able to use only her unified credit and her husband’s unified credit amount to shelter around $20 million of her $30 million estate, resulting in the payment of federal estate taxes at her death.
In this scenario, credit shelter trusts helped minimize additional federal estate taxes resulting from appreciation.
2. Take advantage of generation-skipping transfer tax exemptions. Portability cannot be used for the GST tax exclusion. Therefore, reliance on portability may result in loss of the deceased spouse’s unused GST tax exemption. If a credit shelter trust is used, the assets placed in the credit shelter trust (and any appreciation on those assets) can be permanently shielded from GST taxation if certain tax elections are made. This can be critical for those couples for whom legacy planning is important.
In this evolving tax environment, be sure to consult with your wealth-planning, legal, and tax professionals to reevaluate estate plans currently in place. Important elements to keep in mind:
Unlike portability planning, a credit shelter trust offers no income tax basis adjustment (for computing capital gains) up to market value at the death of the second spouse. Since the exemption amount has doubled, some people may benefit more from the income tax basis adjustment than estate tax savings.
Since many estate plans included provisions for the deceased spouse’s unified credit to fund a credit shelter trust and the unified credit has now doubled under the 2017 Tax Act, the credit shelter trust may receive most, if not all, of the assets in your estate. This may be problematic if you included beneficiaries other than your surviving spouse in the credit shelter trust, which is a common technique if you have children or other family members you wanted to benefit at your death. You should consult with your advisors to ensure your estate plan accurately reflects your wishes.
The increased exemption amounts established by the 2017 Tax Act are not permanent and will sunset on December 31, 2025. They will revert back to their pre-2018 levels ($5 million, indexed for inflation) beginning on January 1, 2026. You should discuss with your advisors the best approach for you given that the increased exemption level is temporary.
Wealth transfer planning is not just about ways to help minimize estate taxes. Consider your family dynamics and financial objectives and the role asset protection might play in helping your wealth grow for your family.
It is important to keep your estate planning top of mind in discussions with your advisors in order to take steps that are appropriate for your particular situation.
1 Please keep in mind that some states have an estate tax and an associated exemption, and credit shelter trust treatment may vary from state to state.
Wells Fargo Wealth Planning Center, part of Wells Fargo Private Bank, provides wealth and financial planning services through Wells Fargo Bank, N.A., and its various affiliates and subsidiaries.
Wells Fargo & Company and its affiliates do not provide legal advice. Wells Fargo Advisors is not a tax or legal advisor. Please consult your legal and tax advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared.
Trust services available through banking and trust affiliates in addition to non-affiliated companies of Wells Fargo Advisors. Any estate plan should be reviewed by an attorney who specializes in estate planning and is licensed to practice law in your state.