FUNDING THE NONMARITAL SHARE IN A CREDIT SHELTER TRUST

By Colleen Cowles

The nonmarital share utilizes the decedent's federal estate tax credit. Regardless of whether the nonmarital share is distributed to a credit shelter trust or outright to beneficiaries (anyone but the spouse), the decedent's federal estate tax credit is utilized. The nonmarital share may be transferred either outright to beneficiaries, held in a credit shelter trust, or a combination of the two. The credit shelter trust may be referred to using other names (bypass trust, family trust, etc.), but regardless of the name, it accomplishes the same thing. This trust is a receptacle for the assets taxed using decedent's estate tax credit. For federal estate tax purposes, the credit shelter trust is the exact equivalent of an outright distribution to beneficiaries other than the spouse. The benefit of using the trust is to hold assets during the surviving spouse's lifetime, rather than distributing them outright on the first spouse's death. If a credit shelter trust is utilized, various options exist for trustee authority in managing the trust.

Use of Credit Shelter Trust

The credit of each spouse may be used by distributing the decedent's assets, up to the applicable exclusion amount, outright to beneficiaries other than the surviving spouse. In many cases, however, this technique is impractical, leaving the surviving spouse with cash flow issues, or simply being uncomfortable with dealing with the death of a spouse and seeing assets transferred outright to others at the same time.

With the use of a credit shelter trust, the decedent's credit may be utilized, while retaining assets in a trust which may still benefit the surviving spouse. The extent of the surviving spouse's rights in credit shelter trust income and principal depends upon specific drafting of the trust which must take Internal Revenue Code restrictions into account. Pursuant to an estate plan put into place while both spouses are living, property in the estate of the first spouse to die may be totally or partially passed to a trust which is included in the initial estate plan for tax planning purposes. Since the surviving spouse does not hold title to the property transferred to the trust and does not have enough management and control of the assets in the trust to be considered a general power of appointment, the credit shelter trust property is not included in the estate of the surviving spouse.

The credit shelter trust uses the applicable exclusion amount of the first spouse's estate after amounts of any outright distributions are deducted. The surviving spouse's applicable exclusion amount may be used at the time of that spouse's death. Therefore, when the applicable exclusion amounts of both spouses are used, assets valued at twice the applicable exclusion amount may be transferred before incurring any estate tax liability. The credit shelter trust may be established by will or in conjunction with a living trust.

During the lifetime of the surviving spouse, distribution of income and/or principal of the credit shelter trust is as provided in the estate planning documents. In drafting provisions of the credit shelter trust, the surviving spouse may be guaranteed income, or income distributions to the spouse may be left to trustee discretion or otherwise limited. Use of the principal of the credit shelter trust must be restricted. Principal may be paid to the surviving spouse, but the method and amount depend upon the provisions of the document creating the credit shelter trust, which must take tax law into consideration.

Credit Shelter Trustee Powers re: Income & Principal Distributions

The most commonly used provisions of credit shelter trusts are the use of a special trustee, the use of the '5 & 5' provision, or the use of the ascertainable standard pursuant to I.R.C. § 2041. Frequently used provisions for trustee authorization regarding distribution of principal and income are discussed below.

1. Special Trustee: A special trustee of the credit shelter trust may be given discretionary power to distribute principal and/or income to the surviving spouse. Since the special trustee is someone other than the surviving spouse, broad discretion may be given to the trustee without jeopardizing the applicable exclusion amount protected by the credit shelter trust. The surviving spouse may be co-trustee of the credit shelter trust with the special trustee, but discretion on distributions to the surviving spouse must be limited solely to the special trustee.
2. Income and 5 & 5 to Spouse: Utilizing the '5 & 5' provision, invasion of principal is limited to the greater of five percent of the principal or five thousand dollars ($5,000) annually. (I.R.C. § 2041) This '5 & 5' restriction prevents the power of invasion from being considered a power of appointment, which would pull all credit shelter trust assets back into the taxable estate of the surviving spouse. However, the spouse's right to invade up to five percent per year will also cause five percent of the credit shelter trust in the year of the spouse's death to be pulled into the spouse's taxable estate for federal estate tax purposes, regardless of whether the withdrawal was made. (I.R.C. § 2041(b)(2); Rev. Rul. 79-373,1979-2 C.B. 331; Treas. Reg. § 20.2041-3(d)(3))
3. Trustee Discretion with Ascertainable Standard: If the spouse is sole trustee, an ascertainable standard (limiting distributions to amounts deemed necessary for health, education, maintenance, or support) must be used in determining what distributions may be made from the trust to avoid a general power of appointment. Pursuant to I.R.C. § 2041(b)(1)(A), the power to make distributions is a general power of appointment which will cause assets subject to the power to be included in the gross estate of the person holding the power except where an ascertainable standard exists. (Treas. Reg. § 20.2041-1(c)(2))
   
   However, if specific language does not meet the requirements for an ascertainable standard (if language does not comply with I.R.C. § 2041 requirements or due to a change in the Internal Revenue Code at a future date), appointment of the surviving spouse as trustee will create a general power of appointment in credit shelter trust assets, thereby causing these assets to be included in the surviving spouse's taxable estate. (Stafford vs. U.S., 236 F.Supp. 132, 15 A.F.T.R.2d 1279, 65-1 USTC P 12,286, (E.D.Wis. Dec 11, 1964))
   
   Treas. Reg. § 20.2041-1(c)(1) also states in the definition of a general power of appointment that a power "exercisable for the purpose of discharging a legal obligation of the decedent or for his pecuniary benefit is considered a power of appointment exercisable in favor of the decedent or his creditors." If the surviving spouse, as sole trustee, has the right to make distributions, subject to an ascertainable standard, to or for the benefit of children and the lineal descendants of any deceased children of the decedent-grantor (and surviving spouse), language should be included to further limit distributions if these amounts could be used to defray the surviving spouse's legal obligations including but not limited to the obligations of support and maintenance.
   
   Although many clients prefer the use of surviving spouse as sole trustee, appointing the surviving spouse as sole trustee does create more risk of losing the applicable credit of the decedent spouse. With the surviving spouse as sole trustee, credit shelter assets may be inadvertently commingled with personal assets, fiduciary records may not be kept, or the credit shelter trust may not be funded. The courts have been very restrictive with ascertainable language, and have denied the applicable credit where language describing the ascertainable standard varied from the Internal Revenue Code.

Plan of Distribution in Credit Shelter Trust

The plan of distribution for the assets in the credit shelter trust at the time of the surviving spouse's death is controlled by the terms of the will or living trust which creates the credit shelter trust. The surviving spouse cannot have the power to change the plan of distribution as to the credit shelter trust assets, or those assets will be considered subject to a general power of appointment to the surviving spouse and will be taxable in the surviving spouse's estate and the decedent spouse's credit will be lost.

Credit Shelter Trust Provisions

The provisions of the credit shelter trust must be in a written document which is executed while both spouses are living, and may be included in a will or in a living trust. However, if the credit shelter trust provisions are included in a will, probate will not be avoided. If joint tenancy or other methods of avoiding probate are used, probate of assets will not be required, but the property will not be subject to the will and the estate tax planning provisions in the will do not apply to those nonprobate assets. The living trust allows the client to avoid probate and to take advantage of a credit shelter trust to reduce or eliminate estate tax. With the living trust, management and control of assets may be retained by the grantors throughout lifetime. Restrictions on management apply only after the death of one spouse, when the credit shelter trust is funded.

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