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Using “just-enough” funding for a credit shelter trust

For many affluent couples, a credit shelter trust (also called a bypass trust) is a key component of their estate plans. This trust type allows spouses to leave as much of their assets as possible to each other while preserving each of their $3.5 million estate tax exemptions.

In recent years, changes in the exemption amount and uncertainty over the future of the estate tax have made it more difficult to design a credit shelter trust. One potential solution to this problem is "just-enough" funding, a technique that allows you to fund a credit shelter trust with just enough assets to avoid triggering estate taxes in the surviving spouse's estate.

Avoiding a credit crisis

Not every married couple needs a credit shelter trust. If your combined estate is well under the $3.5 million exemption amount and you don't expect it to reach that level, a credit shelter trust probably isn't necessary.

Keep in mind that, as of this writing, the estate tax is scheduled to be repealed next year and then reinstated in 2011 with an exemption of only $1 million. Most likely, however, Congress will preserve the estate tax and maintain the exemption amount at its current level or increase it. In addition, states may have different or smaller exemption amounts from state estate taxes.

If you and your spouse have a combined estate that substantially exceeds the exemption amount (or expect to in the future), a credit shelter trust can help you avoid a multimillion dollar estate tax bill. Here's how: Suppose you and your spouse each have an estate valued at $3.5 million. If you die when the exemption amount is $3.5 million and leave your entire estate to your spouse, there's no estate tax because of the unlimited marital deduction. But if your spouse dies with a $ 7 million estate, and the exemption amount remains at $3.5 million, his or her estate will owe $1.575 million in federal estate taxes (assuming a 45% marginal rate).

In the above example, by leaving your entire estate to your spouse, you essentially wasted your exemption. you _could have avoided this result by leaving the entire $3.5 million to a credit shelter trust that provides your spouse with income for life and transfers the remaining assets to your children or other beneficiaries. The trust would take full advantage of your exemption amount, and it would bypass your spouse's estate, thus eliminating estate taxes.

Arranging flexible credit terms

Credit shelter trusts are ideal if you and your spouse can predict with reasonable certainty the size of your estates and your exemption amounts when you die. In the recent past, it was common for an estate plan to provide for an amount equal to the exemption amount to be placed in a credit shelter trust. But this strategy is less effective when the exemption amount is subject to change.

Suppose that you and your spouse each have an estate valued at $2.5 million. Conventional wisdom says that you should use a credit shelter trust to take advantage of your exemption amount and minimize taxes in your spouse's estate. But what if Congress raises the exemption amount to $5 million next year? That would allow you to leave your entire estate to your spouse without adverse tax consequences (unless you expect your spouse's estate to grow substantially in the future).

Of course, you could revise your estate plan regularly to reflect changes in the exemption amount and the size of your estate. But what if you forget or one of you becomes incapacitated? Some couples are using the technique of "justenough funding" to build flexibility into their plans, minimizing estate taxes while maximizing the amount of assets left to the spouse outright.

Using the previous example, if the exemption amount remains at $3.5 million, a just-enough approach will fund the credit shelter trust with $1.5 million and transfer the remaining $1 million to your spouse, leaving him or her with a $3.5 million estate.

Be aware that you can achieve an identical result by leaving your entire estate to your spouse and permitting him or her to file a qualified disclaimer directing some or all of the assets into a credit shelter trust. But the just-enough technique avoids the risk that your spouse will make a mistake or otherwise fail to make the appropriate disclaimer.

Getting it “just right”

The IRS hasn't officially sanctioned just-enough funding, but in at least one request for a private ruling the agency suggested that the technique is sound. If you're looking for a way to minimize estate taxes without putting any more than necessary into a credit shelter trust, just-enough funding may be just right for you.
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