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- [00:00]
A
Foreign.
- [00:12]
B
Welcome back, everyone, to another episode of the Practical Planner podcast. I'm your co host, Thomas Goldman, here with both of my other co hosts today. I think this is the first time and probably going to be the only time, at least for a few months until Ann gets back. Ann is very quickly approaching having her second child. So super exciting. We are very happy that you were able to give us a little bit of time before that happened. So, Ann, welcome. David, welcome. How you guys doing?
- [00:39]
A
Good. I mean, at any day, any day now, I could pop. So I'm just really happy to have this opportunity to film one more of these or record one more of these episodes. And so if you guys have any questions, please, during the time that I'm out, you are in good hands with Thomas and Dave.
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B
Well, you know, what better use of your last couple days before having a baby than talking about credit shelter trust, right? I mean, this. Nothing seems more like you than exactly what we're doing here right now. So for everybody, just to kind of give you a quick outline of what we're gonna talk about today, we're gonna talk about credit shelter trusts, what they are, the value of them, why they're used. We'll talk a little bit about survivors trust and then a bit little, A little bit just about how they're different than marital trusts. So, you know, credit shelter trusts, what even are they? Why do we need to know about them as advisors?
- [01:35]
A
Well, credit shelter trusts are formed usually to do tax planning. And so credit shelter trusts, unlike marital trusts, have a very tax driven motivation behind them. Marital trusts may be a little bit more about, like controlling assets, you know, the inheritance as it goes to your spouse. But at the heart of them, the credit shelter trust, I mean, it's kind of in the name, right? Like you're sheltering somebody's credit is about preserving a tax attribute. And so you can have a credit shelter trust even if you have no qualms normally about giving everything outright to your spouse. And then Dave, maybe, you know, do you want to talk a little bit about some of the differences and how they can be structured, marital trust versus credit shelter trusts, and what exactly credit shelter trust will do for you?
- [02:34]
C
Sure. Yeah. So credit shelter trust, like Ann was saying, is, you know, primarily used for estate tax purposes. It's really important that you know whether you have a state tax issue if you're going to use a credit shelter trust, because there can be some downsides to using a credit shelter trust in a circumstance where you have no estate tax issue at all. For example, you know, I come from Massachusetts, there's a very low estate tax threshold that was 1 million, just recently went up to 2 million. So when I was practicing, you know, most clients that would come into the office if they owned, at least owned some real estate, they were going to have need for some estate tax planning and therefore might have the need for a credit shelter trust. And what the credit shelter trust is, is it preserves the estate tax exemption of the person who passed away so that they don't waste it. And you know, there's some nuances to this on federal versus state. But just to put it really simply, if you have two spouses, let's say in Massachusetts they had $4 million, one spouse passes away, gives it all to their surviving spouse. Now that surviving spouse passes away, they didn't have to pay any taxes because there's an unlimited marital deduction, but they died with $4 million. And so there's going to be a tax because it's over that 2 million dollar threshold. If they had done a credit shelter trust at the time of the first death, they would have been able to preserve the 2 million of the first person who passed away. So when the second spouse passes away, two millions in the Credit Shelter Trust, two millions in their name alone, so no estate taxes. To put it in a very simple.
- [04:22]
A
Terms, I was going to jump in and say, you know, it's interesting you mentioned Massachusetts, right, Because there's a decoupled state estate tax where the threshold is super, super low. Here in California, you know, all of a sudden when the especially the exemption like went way, way high. And on top of that the, the gift and estate tax exemption could be unified, portable, portable so that the second spouse, you wait until the second spouse's death to fully utilize, you know, both spouses exemptions. A lot of folks thought, hmm, maybe that, you know, that has fallen by the wayside because California doesn't have a state estate tax and only I think 13 states in the nation do. But actually there is still very much a point to having a credit shelter trust because honestly if there is any estate tax issue at death potentially, and this can happen for two reasons, and I'll mention them, you this is like what we call Hail Mary planning. So like at least preserve the option to have a credit shelter trust in your documents, don't have to exercise it, but let somebody form the credit shelter trust in case it becomes relevant. And those two reasons are the exemption goes down, right? And so that exemption amount right now is 13.61 million, but it is A political football and depending on the administration, political, you know, headwinds that could go down. And it's been historically as low as I think 350k or 500k. Dave, correct me if I'm wrong, like something very low. Even at the federal level.
- [05:59]
C
Yes, yes, it's been very low.
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A
Yeah.
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C
Not, not super, super long ago.
- [06:04]
A
Yeah. And then what we all hope for our clients is that they hit the jackpot and literally you could have a who goes and plays Powerball and all of a sudden their wealth rises tremendously. And all of a sudden, if they pass away without having reviewed their documents, at least you have the credit shelter trust option in there. So.
- [06:23]
B
So I want to go back to a point that you made there that like at least have the option in the documents. When you say that, what does that really mean? Is that something like, as an advisor we should be looking out for as part of the documents. Because going back to what David said, right. Like this is something that is really created upon the first passing. So I'd love to hit on the first question. But then also like, is that only when it makes sense, you only create them upon one passing. Is it something that is ever thought about before?
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A
Yes.
- [06:51]
C
So there's really, there's a couple of ways to make this happen. When it comes to preserving the exemption at death, doing a credit shelter trust, one of the ways is you can put what's called a funding formula into the documents themselves, hard coded, that will kind of tell you, well, if this spouse dies, it looks at what the exemption amount is and it kind of allocates money automatically to a credit shelter trust. There's a number of different structures to it, but let's say to a credit shelter trust, and that preserves the exemption automatically. So you're kind of taking away action of the surviving spouse of needing to assess where things are at because there's this automatic formula to make it happen. That's fine. The issue with that is that long ago, like Ann was mentioning that the estate tax threshold was very low, some people who had in their documents this automatic funding formula that mandated a certain amount go to the credit shelter trust only to later find out that the estate tax exemption skyrocketed to where they would have no reasonable reason to have an estate tax issue. That is problematic because when assets go into a credit shelter trust and the second spouse passes away, those assets are not afforded a step up in basis. So what that means is between the time of the death of the first spouse and the time of the death of the Second spouse, any assets in that credit shelter trust that have appreciated, let's say it's stock, let's say it's real estate. Whatever the case is, the they're going to have to pay capital gains tax upon liquidation even if the surviving spouse passes away, whereas if the surviving spouse had just received that outright, they would have gotten the second step up in basis. So it's not always great to have a formula in place that's really rigid, that kind of boxes you in needing to do estate tax planning if you don't have to, because there can be some negative, negative implications as far as taxes. On the other side of that, you can make it more flexible, and in most circumstances you should make it more flexible depending on the family dynamic, because you can leave it so that the surviving spouse has the option upon the first death whether to fund the credit shelter trust. And that's usually done. It can be done through what's called a disclaimer, which essentially means that the surviving spouse is saying, I know I am entitled to this property, I can take it into my own name, but I don't want it. I'm going to push it over into this credit shelter trust. They have nine months to do that after the death of the first spouse. There's not a lot of rules involved in it, but it's a flexible way of planning to be able to get assets into the credit shelter trust after death and being able to look at the situation. Then, you know, what's the estate tax situation, how much control do I want over the assets and kind of make a decision at that time. One other thing I just want to make clear is that when you put assets into the credit shelter trust, you're not necessarily giving up control of them. Like it's going into an irrevocable trust that you can't touch. In a lot of circumstances, a surviving spouse can be the trustee of that credit shelter trust and they can have a right to distribution of income and even a distribution of principal from that trust, depending on who the trustee. It depends on how much access they can have to it, but it's usually pretty liberal that they're going to be able to get that at those assets if they need them. Usually they don't want to touch them because they're for estate tax planning, but if they really need them, there's usually a spout to be able to get them out.
- [10:33]
A
And here I just want to mention a couple of things too, about the flexibility. Also about forming a credit shelter trust. I think it goes without Saying that if I've ever heard horror stories from financial advisors and wealth managers is that when the spouse was stuck with one of these rigid funding formulas that forced them to live with a credit shelter trust, right? Because let's say what the funding formula says is fund up to the exemption into the credit shelter trust. You know, most people don't have more than 13.61 million. So if you die, you know, with 3 million, your spouse has to live with a $3 million credit shelter trust. And this is where people stop following the trust. I have heard horror stories like that where people were like, my God, I'm just going to pretend this trust doesn't exist in the documents, right? And then you get into all sorts of other problems, which is once that second spouse has died, you know, the IRS may look at this or the state, you know, taxing authority to say, hey, did you properly file income tax returns for this entity? You never formed. You can have beneficiaries who are upset because truthfully, the spouse couldn't just use the assets as, as though they owned them outrigh. They just ignored the existence of this trust. And so you get into all of these like administration questions where people like, I've had, you know, to clean up messes where clients didn't follow the credit shelter trust that was created for them. And so just be careful, you know, like, that's the only thing that I'll say about as a financial advisor, you know, what your role should be in this. I will point out that in the wealth.com forms, if you've ever gone through the workflow and you're like, nope, nope, nobody needs a trust. Nobody has any control issues. And then all of a sudden you look at your client's document and you find something called the family trust in there. We have automatically put in a credit shelter trust. We call it the family trust because it sounds nicer, friendlier, but that's what it is. And we fund it through a disclaimer by the spouse or the partner, the though in a committed relationship or something like that. But we do have that optionality again because if your client happens to die having won the lottery, that is like the last stand to create as exempt of a trust as possible from taxes with your client's exemption amounts.
- [13:02]
B
Super interesting. I'd love to go back on this formula side of things and maybe one of you guys talk about an example or something, but I would love to like kind of get a, give everybody a feel of like, what, what does this look like in practice? Sometimes what does it actually mean when it's restrictive? Right. And like the opposite of what you want? And then what is some of the language or how do you structure in a way that does create flexibility?
- [13:25]
A
Yeah, I think stepping back, the first thing to know about this term, like funding formula that you may have heard is that usually funding formula is, is it's. It's like a sliding scale. Think of it this way. Your client passes away with a set worth of assets, value of assets. Let's say it's that, you know, $10 million, and you have a sliding scale as to, like, how much to put into a trust versus some other place. And that other place could be outright to the spouse. It doesn't have to be a trust, but it could actually be a marital trust as well. Right. So your credit shelter trust could be paired with a marital trust. And then I'll talk about survivor's trust. But it could be, you know, it's basically like you have a choice to make as to two different allocations, and it happens to be that one of them is the credit shelter trust receiving assets. So the funding formula hard codes into your documents, how you slide the scale so that you determine, hey, of that 10 million, how much goes into the credit shelter trust versus anywhere else. So again, if you do have a client who has some control concerns over the spouse, so wants the marital trust and also may have estate tax problems either at the federal, state level. This is where the common parlance calls them AB trust structures. A would be the marital trust, B would be the credit shelter trust. And so the funding formula just slides the scale between two trusts or two places. Now that sliding scale can be locked in. So as Dave was mentioning, one of the common ways to lock that in is to say, hey, up to the exemption level, either at state or federal level, however the document is drafted, you have to fund that amount into the credit shelter trust so your client passes away. Dave, can I say California, just for this example, with $10 million, it's a lot of money and there's no state estate tax. And so they pass away with just the federal estate tax exemption to think about. And so that's 13.61 million. All 10 million has now got to fund into the credit shelter trust. The funding formula I just told you is like the conceptually, the easiest one to understand. And it is called a pecuniary gift to the credit shelter trust. You will hear all sorts of names for these funding formulas because that sliding scale can be set in many different ways. But you know, the Disclaimer is where the spouse, it has complete control over the sliding scale. That's like the opposite end of the spectrum from rigidity because this is the spouse literally under the code having to fill out some paperwork saying I disclaim up to she could choose $1 all the way up to the 10 million to say that's what I choo to put in the credit shelter trust. So that kind of gives you a sense for the range that the sliding scale can go under. But that's baked into your documents. How do you slide the scale?
- [16:40]
C
Yeah, and I just, just to follow up on that, you know, reviewing so many documents from advisors, I would say that that was so commonplace back before the estate tax exemption really skyrocketed. Even first when I went to 5 million back, you know, let's say over a decade ago that these rigid funding formulas that are really disadvantageous for clients are, I'm telling you, is probably the most common comment I would have on trusts that I would review. So they are out there. There are a ton of them that need to be updated or else there's going to be a lot of capital gains taxes that are unnecessarily paid.
- [17:25]
B
So this is, right, the perfect place for an advisor to actually add value. Right. You don't necessarily have to know the formula. Perfect. You don't necessarily have to know this. But here's a practical point to review and probably even another thing to then review again in two years. Right. So like is the estate tax threshold staying the same? If so, okay, we probably have some revisiting to do here.
- [17:44]
A
Yeah, I think that in 2017, when the exemption doubled, right. So it was 5 million adjusted for inflation. So at the time was about 7 million. And all of a sudden like, or actually it was like 6 million. But anyways it doubled all of a sudden. All these plans that Dave is reviewing just become like horrible results for the surviving spouse. And so I think estate planners like had a wake up call in that moment being like, oh my gosh, then it's going to sunset again in 20, you know, December 31, 2025, at the stroke of midnight, that exemption is going back down automatically by law by half the. So like do I have to continuously be improving, you know, and updating the plan and will I have clients have to redo their plans in 2026. Right. And so I think estate planners got savvier. I know at Perkins Coie we decided to use disclaimers and also something called a Clayton Q tip election which I wanted to just briefly Mention, because remember I said you can pair the marital trust with a credit shelter trust. You can have both in the same document. The Clayton Q tip is like, it is the flexible sliding scale. But when you have both trusts and you don't always trust the spouse to disclaim, that's the important thing. Right. Notice with the disclaimer we keep saying like, somebody's got to give up assets. You could have a spouse who, you know, doesn't know, isn't sophisticated enough and within nine months doesn't catch that they need to do that. But hopefully the trustee would catch that there is an estate tax issue and that what that Clayton Q TIP formula does is put additional power in the hands of somebody who's not the spouse. So, like the trustee to make an election with respect to the two trusts and determine how much and which assets to put in the credit shelter trust where they lose the basis, step up and how much to like keep within the marital trust. That's basically what that claim Q10 does.
- [19:49]
C
The other good thing is the, the Clayton, typically you actually have more time to make the election than with the disclaimer. Disclaimer you have nine months. With the Clayton Q Tip, you effectively can usually get 15 months. So a little bit more restrictive in a certain way, but there's more time there to be able to make an election.
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B
So is there better assets that go in credit shelter trust than in other accounts?
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A
Yes, absolutely. Dave, maybe you want to talk about that because you love basis stuff up, I think.
- [20:27]
C
Yeah. No, yeah, I mean, I mean, yeah. Number one, obviously if something's, you know, it. It's funny with the credit shelter trust because you lose a step up in basis. But you know, when you're funding the credit shelter trust, you're trying to get assets out of the estate and you want to get the appreciation out of the estate as well. Right. Because once you get those assets out of the estate, they're going to grow outside of the estate. So you always have one mind thinking about capital gains, but you're also thinking about the estate tax bill, which, you know, that's 40%. The capital gains tax bill is probably at max 20. So a lot of times you're going to favor funding the credit shelter trust if it's going to save you on estate taxes, you know. But there are a lot of assets that you don't necessarily want to go into the credit shelter trust, number one, might be your primary residence. That's something that typically, if you're going to choose what assets to fund it with, that's not always the best. You know, there are, first of all, you know, with the deed, it can get complicated on how you're going to allocate that property to the trust. But also, you know, preserving things like the capital gains tax exclusion at death, if you were to sell it, you might be giving up some tax benefits there that would kind of, you would rather put maybe an investment account or something else into the credit shelter trust. The other thing is, you know, let's say someone's heavily weighted towards retirement accounts. You know, naming the credit shelter trust as the beneficiary of an IRA isn't necessarily a great result. Right. Because that is going to obviously have to come out and they're going to have to pay taxes on that. And if you're going to be funneling those RMDs back to the spouse, you're just going to be having the assets come out of the credit shelter trust back into their estate anyways. So those are two kind of top of mind assets you'd probably want to typically avoid going into the credit shelter trust. Sometimes you don't have any choice. But those are two that come to mind.
- [22:25]
A
Yeah, this is where you know, as much as we love planning and we think we can project into the future, unfortunately you just don't know what your clients are going to pass away with, both the asset composition, how much the situation. And so that's why preserving that flexibility so that you can assess what's in the estate at the point in time where they pass away is generally preferable. But of course then you need good advice. You need professionals, maybe tax professionals and attorneys, potentially even involved. But this is where you can bring a lot of value too because you will have a look into what those assets are and advise the client's spouse, you know, the surviving spouse on how to do those allocations. So there is a tremendous opportunity for you as a financial advisor to step into that role at death and you know, run that balance sheet, take a look at what makes sense. You know, here in California, for example, because our state income tax is so high, right. Over 12% when you attack that onto, you know, the federal bill, actually that estate tax concern may be a little bit less. Right, that 40%. And so it just, it really depends on where your client passes away, what they passes away with and how much of each asset. So that gives you an opportunity, anytime there's uncertainty, it's an opportunity for you to bring certainty and clarity in that moment in time.
- [23:56]
B
Totally. And I know one thing that you wanted to hit on in this episode is also about survivors trust and you know, why they're used in community property states. So I'm going to. That's, that's your wheelhouse, not mine. I'm going to let you answer that one.
- [24:10]
A
Yeah, I think this episode can be titled like the three most common types of trusts for spouses and what happens upon the first death. So the survivors trust I wanted to bring out because, well, first of all, a lot of our audience I think have clients who have joint trusts or live in community property states where joint trusts are really, really common. And so the survivors trust comes. But it's also because we earlier mentioned like the common term for this type of, you know, what we're talking about is AB trust structures. With a survivor's trust, you're looking at ABC trust structures. People are super creative in naming these. And so with the ABC trust structure, it's really just adding on one extra trust type. So that survivor's trust, what is it? Is it about tax planning? Is it about control? The answer is neither of these actually. The survivor's trust is and should be a completely revocable trust that only gets formed at the first death. You know, first spouse has passed away because you need a place to put the survivor stuff. They should still have a plan in place. Just because their spouse has passed away doesn't mean that all of a sudden all the good estate planning they did, you know, 20, 20 years ago or five years ago should like, poof, go away. You need a place for the widow or widower's assets to go. And so that survivor's trust is really for all intents and purposes the survivor. It's as though you put assets in their name, but you're just continuing the revocable trust structure because for whatever reason, as good of a reason as they had to form the joint revocable trust, they have a good reason to continue an individual revocable trust. And so when you think about, you know, in certain states like Massachusetts, if you were to have an individual revocable trust and you passed away, you have a choice. Like the big choices, do you want your assets to go to your spouse outright in their own name or in a marital trust, you know, that's a big deal. The survivor's trust is outright in their own name. That's like the complete equivalent. So if you decide to pass assets to your spouse outright, but you live in a community property state, then actually what might happen is what we override the outright in your own name, but put it Straight into their survivor's trust so that you don't have to do funding twice. So like put it in their own name and then they have to pick up the asset and retitle it in the name of their survivors trust. That's the point.
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B
That makes sense. Okay, what have we not hit on as it relates to credit shelter trust? Is there anything that we need to make sure that we get across or you feel like we've hit it all?
- [26:59]
A
I think we hit it all. I think of the credit shelter trust as like a super estate tax exempt structure. I think the credit shelter trust is important for everybody to have. Even if you think your client like there's no way in hell that they're going to have like, it doesn't hurt to just put it in.
- [27:17]
B
You mean have the option? Right. So in the documents have the option to use it if they want to. And so it's not that everybody needs it, everybody uses it, but everybody should have the option to potentially use it because you don't know what it could look like 20, 30, 40 years from now or exactly.
- [27:32]
A
Thomas? Yep.
- [27:33]
C
Couple extra pages in your document, maybe maximum, you know, that could offer so much in savings, so might as well have it.
- [27:43]
B
Yeah, makes sense. Well, this was a, you know, in depth topic. I feel like these ones are super helpful. Honestly for me as a financial planner and I know everybody listening, this is going to be something that's going to help make you, you know, better educated and have better conversations with your clients and be able to help add more value so you can know to look for these things. But Ann, I just want to say thank you for coming on. I know we're not going to see you here for a few months. David and I are going to hold it down, but we'll be very excited and we'll say don't worry. All the meaty, deep topics for you when you get back because we know you love those.
- [28:14]
A
That's right. If you have questions about funding formulas or whatnot, I guess, you know, let us know. We didn't want to overwhelm you with details, but you know, it's been such a pleasure recording these podcast episodes so far and I'm going to miss this the most, I think, of anything I do at Wealth. Thank you for listening in.
- [28:33]
B
Yeah, me too. Well, everybody, thank you for listening again. Please rate and subscribe. Help us comment. Continue to grow this podcast. We can keep putting out great episodes for you, but until next week.