This modest illustration demonstrates how the typical credit-shelter trust can be very costly to a large number of married couples if the trust is not purposely designed as a defective trust for income tax purposes. Income tax planning now is a mandate for estate planning.
In this example, a $4 million beneficiary defective credit-shelter trust during the surviving spouse’s 20-year remaining lifetime saves approximately $1 million of income tax.
This income tax savings over the surviving spouse’s 20-year lifetime (in this example) has two components:
$541,000 in income tax savings. This is 20 years of avoiding the more compressed top marginal income and capital gain tax rates for trusts, including the 3.8% Medicare investment tax; and
$357,200 in income tax savings. This is at the end of the 20-years getting a second stepped-up cost basis for the credit-shelter trust assets at the surviving spouse‘s death.
This John / Jane Credit-Shelter Trust Example
John Smith dies at age 77 with $4.0 million of his own property. His wife Jane, age 68, has $1.5 million of her own property, plus social security and a modest source of her own income. Jane is in excellent health and expected to live at least 20 years following John’s death. She would like ideally to preserve the credit-shelter trust for the children and grandchildren.
John’s $4.0 million estate passes into his credit-shelter trust for Jane’s benefit. This credit-shelter trust is designed purposely as a beneficiary defective trust as to Jane during her remaining lifetime.
Assume the $4.0 million credit-shelter trust produces a $320,000 annual return of 8%, consisting of $256,000 capital gains and $64,000 ordinary interest income [roughly an 80 / 20 asset allocation].
Income Tax Illustration 1: A Non-Defective Credit-Shelter Trust
The annual $64,000 ordinary interest income and $256,000 capital gains for a non-defective credit-shelter trust produce the largest amount of annual income tax: $86,478. This each year includes $11,695 of 3.8% Medicare investment tax. The ordinary income and capital gains are taxed at the credit-shelter trust tax rates. [Computed using 2013 rates.]
Income Tax Illustration 2: A Beneficiary Defective Credit-Shelter Trust
By contrast, this beneficiary defective credit-shelter trust results in the interest income and capital gains being taxed at Jane’s own personal income tax rates, including her less-costly threshold for the 3.8% Medicare tax. The higher marginal trust rates do not apply.
This defective trust status reduces the annual tax to $59,405 (compared to the $86,478 trust income tax above). This defective status saves Jane $27,073 in income tax each year [$59,405 annually compared to the more costly $86,478].
This annual income tax savings includes $7,135 less each year for the 3.8% Medicare tax compared to the above non-defective trust approach.
This annual income tax savings over Jane’s 20-years will enhance the credit-shelter trust value by $541,460 [20 times $27,073].
Additional Income Tax Saving for a Second Stepped-Up Basis
For a typical credit-shelter trust there is no stepped-up basis for the trust assets when the surviving spouse dies. But, by contrast, it is this purposeful beneficiary defective trust design in this example that results in John’s credit-shelter trust assets getting a second stepped-up basis at Jane’s subsequent death. This is an additional level of income tax savings. [The first stepped-up basis was at John’s death.]
Assume, for example, the market growth of the $4.0 million credit-shelter trust assets during the 20 years following John’s death increases 2% each year (in addition to the above annual 8% return). This results in a compounded increase in the trust assets from $4.0 million to approximately $5.9 million. This $1.9 million increase is the unrealized gain growth during the 20-year period at Jane’s death.
At Jane’s death this $1.9 million growth will get the benefit of a stepped-up basis. Thus, no taxable gain to the children. This saves an additional $357,200 of capital gains tax [18.8% tax rate times $1.9 million; using a 15% capital gains rate plus the 3.8% Medicare tax].