27-Mar-20
Reconsider q Credit Shelter Trust
Take-Away: For the last several years the focus of estate planning has been on income tax saving strategies moreso than estate tax saving strategies. With the present recession much of the capital gains that those income tax strategies had hoped to avoid with a step-up in income tax basis on the owner’s death were suddenly eliminated by the market’s abrupt response to the coronavirus. The viability of some planning strategies, like portability and credit shelter trust, should now be reconsidered in light of the ‘new normal.’
Background: In addition to the dramatic drop in market values in this coronavirus driven recession is the reality that many individuals may soon have creditor problems with the economy effectively ‘shut down.’ These changes should warrant a reconsideration of some of the popular ‘free-basing’ planning strategies of the past 7 or 8 years, including the wholesale reliance by a married couple on portability of a deceased spouse’s unused federal transfer tax exemption. Obtaining a fresh income tax basis on the surviving spouse’s death may not provide as much tax-savings benefit as originally thought when balanced against some of the risks of giving full control over the assets to the surviving spouse.
‘Step-Up’ Misnomer: If anything, this month’s recession and market collapse is a painful reminder that asset values do not always increase merely with the passage of time. Hence the misnomer a ‘step-up in basis on death;’ a better description of IRC 1014(a) should be a fresh start income tax basis adjustment on death.
Biden Backdrop: Bernie Sanders is not the only candidate with a radical transfer tax agenda. Vice President Biden has essentially adopted almost all of President Obama’s proposed tax law changes during his last years in office.
Tax Exemption Proposal: One such proposal is the reduction of an individual’s lifetime gift or estate tax credit from the current $11.58 million to a flat $3.5 million.
Carry-Over Basis Proposal: In addition, Mr. Biden proposes to eliminate the ‘step-up’ in income tax basis on a decedent’s death, (excluding $500,000 of assets) in effect a repeal IRC 1014(a).
2020 Election: While it remains to be seen if Mr. Biden is elected President, or if Congress changes its make-up with Democrats in control of of both Houses after 2020, that is a possibility that should be considered when making an estate planning recommendations that relies on portability.
No Tax ‘Increase:’ Remember that Congress cleverly increased revenues yet it did not increasetaxes, when it adopted the SECURE Act’s 10-year payout rule for inherited qualifed plans. Similarly, Congress could easily increase revenues to pay for the $2.2 trillion recession bail-out legislation not by increasing taxes per se, but simply by repealing IRC 1014(a), and exposing all inherited assets to carry-over income tax basis on the owner’s death.
Portability: One simple example of the ‘free-basing’ approach to current estate planning is for married individuals to rely on the portability of a deceased spouse’s unused federal exemption amount. By electing portability, the surviving spouse has access to the deceased spouse’s unused estate and gift tax exemption to shelter more assets from federal estate taxes on the survivor’s death. [IRC 2010(c).]
Simplified Planning: Portability thus leads many married couples to abandon the former credit shelter trust planning and opt for an outright bequest of all the deceased spouse’s assets to the survivor, or the decision to use a joint trust where the surviving spouse is left in full control of all of the joint trust assets. With that control comes federal estate tax inclusion, and thus a fresh income tax basis for all of those assets on the survivor’s death.
Second Basis Adjustment on Survivor’s Death: The free-basing motivation is that all of the married couple’s assets will receive a second income tax basis adjustment on the surviving spouse’s death, thus eliminating any capital gain exposure with regard to all of the survivor’s assets. In short, the children of the married couple will inherit all of those assets on their surviving parent’s death with a new date-of-death income tax basis, and consequently the children will be able to liquidate the inherited assets (other than retirement account assets, which are income in respect of a decedent) without incurring any capital gain tax.
Trade-Offs to Portability: However, relying on portability to obtain the second income tax basis adjustment on the surviving spouse’s death carries with it practical trade-offs.
Survivor Goes ‘Rogue:’ Perhaps the biggest concern is that the surviving spouse is left in control of all of the marriage’s assets and thus is capable of diverting those assets away from the children, e.g. the survivor may remarry and expose the assets to spousal elective rights, or the survivor may exercise his or her control and leave all of the assets to a charity. [Years ago, in discussing this risk with my older clients, I referred to the survivor being persuaded to leave all of his/her assets on death to Reverend Moon to carry out his ministries, doing God’s work while driving a Rolls Royce auto.]
Exposing Assets to Survivor’s Creditors: In addition, with all of the married couple’s assets in the name of the surviving spouse, intentionally done so that those assets will be included in the survivor’s taxable estate and thus warranting an adjustment to the assets’ income tax basis, also exposes all of those assets to the survivor’s creditor claims.
Credit Shelter Trust: In contrast to an outright bequest to the surviving spouse, or the use of a joint trust which assume a portability election with the goal of a second income tax basis adjustment, diverting part of the marital estate on one spouse’s death to a credit shelter trust avoids the risk of the surviving spouse leaving the assets on his or her death to someone who is not part of the family, or the risk of exposing those assets to the surviving spouse’s creditors.
The transfer of those assets to the credit shelter trust will be exempt from federal estate taxes on the first spouse’s death, because the decedent’s exemption will be used at that time; nor will the trust’s assets be exposed to federal estate taxation on the surviving spouse’s death since those assets were owned and controlled by the credit shelter trust, not the surviving spouse.
No Second Tax Basis Adjustment: If assets are transferred to a credit shelter trust with the direction to pay all income to the surviving spouse, and in the trustee’s discretion pay principal to meet the surviving spouse’s health or support needs, then the trust’s assets will not be included in the survivor’s taxable estate. Concomitantly, those same assets (held in the name of the trust) will not be exposed to a second income tax basis adjustment on the survivor’s death. Thus the principal drawback to using a credit shelter trust.
Creative Planning- Formula Based Testamentary Power of Appointment: While the above discussion seems to imply an either-or estate plannning choice between a full portability election, or foregoing portability with the use of a credit shelter trust, it is possible gain the benefit of both options- retain control by the trustee so the remaining assets pass to the children, protect trust assets from the survivor’s creditors, yet gain some or a full income tax basis adjustment on the survivor’s death. As noted above, the assets held in the credit shelter trust will normally not be subject to a second income tax basis adjustment on the surviving spouse’s death. However, it is possible to give to the surviving spouse beneficiary of the credit shelter trust a testamentary general power of appointment that will cause some, or all, of the assets held in the credit shelter trust to receive an income tax basis adjustment.
All Assets Receive Basis Adjustment: One possible solution is to give the surviving spouse a testamentary power of appointment to use credit shelter trust to pay creditors of the survivor’s estate. The mere presence of this testamentary general power of appointment, whether or not exercised by the survivor, will result in an income tax basis adjustment of all credit shelter trust assets. While that may be beneficial, it could also cause the survivor’s estate to actually have to pay a federal estate tax.
Limited Step-Up in Basis: Another possible solution is to give the surviving spouse a testamentary general power of appointment to appoint assets in the credit shelter trust, but limited to only those assets which have a current value higher than their income tax basis, to whomever the survivor pleases. This provision would expose those appreciated assets to an income tax basis adjustment on the survivor’s death, whether or not he or she actually exercised the power of appointment. Other assets held in the trust would not receive any basis adjustment. However, the risk remainsi that the survivor might actually exercise that testamentary general power of appointment, albeit limited, away from the remainder beneficiaries of the credit shelter trust. This approach only seeks to identify those assets that would benefit from an income tax basis adjustment.
Formula Power of Appointment: A third option is to give to the survivor a formula based power of appointment that would expose some credit shelter trust assets to an income tax basis adjustment, but which would not risk causing a federal estate tax liabilty to the survivor, if the value of all of the credit shelter trust assets were included in the survivor’s taxable estate.
Example: My surviving spouse under this credit shelter trust a testamentary general shall hold a testamentary power of appointment over such trust assets or amounts which, when the trust asset values are added to the values included in my surviving spouse’s taxable estate will result in no federal estate tax liability owed by my surviving spouse’s estate to the United States Treasury.
This formula approach limits the power of appointment by the amount necessary to obtain some basis adjustment but not at the expense of creating additional federal estate tax liability.
Conclusion: With the significant drop in market values, low interest rates, and a society in turmoil, there might be renewed interest in using a credit shelter trust for a surviving spouse. A change in the make-up of Congress, or the White House, could also provide an incentive to no longer rely on the principle of portability around which to build an estate plan.