Credit Shelter Trusts Explained

As long as people have been assessed taxes, they have looked for ways to avoid them. One legal way for well-off couples to avoid estate taxes or lower their burden is by establishing a credit shelter trust.

What Is a Credit Shelter Trust?

A credit shelter trust (CST) is a legal trust that allows couples to reduce or eliminate estate taxes that are assessed on assets they pass on to heirs, whether the heir is the surviving spouse or their surviving children. 

This irrevocable trust specifies that when the trust's creator or settler dies, the assets listed in the trust agreement are transferred to the settler's spouse or children.

This type of trust is created after the death of the first spouse in a married couple. It includes some or all of the person’s estate. Assets placed in the trust are typically held separately from the estate of the surviving spouse. This allows them to pass tax-free to the remaining beneficiaries at the death of the surviving spouse. The CST’s assets can be used by the surviving spouse during his or her lifetime.

Credit shelter trusts are also commonly known as family or exemption trusts. They are also sometimes called bypass or AB trusts, because they “bypass” situations in which each spouse has a separate taxable estate, known as A trusts and B trusts.

How a Credit Shelter Trust Works

A CST is managed by a designated trustee. Thus, the surviving spouse has no legal control of the trust's assets. Because of the, the assets transferred to the spouse are not included in the surviving spouse's taxable estate. 

Estate Benefits of a CST

One key benefit of a credit shelter trust is that the surviving spouse has certain rights to the assets in the trust as long as they live. Under certain allowable situations, including certain medical or educational expenses, the surviving spouse can use the trust's principal as well as the income it generates. 

When the surviving spouse dies, the trust's assets are transferred to the remaining beneficiaries without any estate tax assessment.

Tax Benefits of a Credit Shelter Trust

A credit shelter trust allows a married couple to legally benefit from estate tax exemptions. In 2021, the estate, gift and generation-skipping transfer (GST) tax exemption is $11.7 million per person, with a top tax rate of 40%. This amount is set to “sunset” at the end of 2025, to pre-2018 levels to approximately $6 million ($5.6 million adjusted for inflation). 

The Biden Administration is proposing changes to the tax laws, however. Consult with a tax expert for current exemption limits and other rules.

Other Benefits of a CST

A credit shelter trust has other advantages as well:

• Asset protection. A CST protects the assets of a surviving spouse from, for example, creditors, children or a new significant other, so they cannot use those assets inappropriately or to pay their own debts.
  
  
• Inheritance protection. If the current family is blended from other previous families, each spouse can ensure that their portion of the estate passes to their chosen beneficiaries – for example, children from a previous marriage – as well as to a surviving spouse’s beneficiaries.
  
  
• Flexibility. The trust can be written to allow for a limited power of appointment for the surviving spouse. For example, the surviving spouse may be able to move the assets to a new special needs trust to provide for a child who developed a need for more care after the death of the trust’s creator.
  
  
• Maximize the Generation-Skipping Tax (GST) Exemption. The GST exemption is not portable. But a bypass trust can allocate the GST to a GST-exempt bypass trust, which preserves the exemption for children.
  
  
• Protecting against taxes on asset growth. An asset portfolio of stocks and property that is in a CST can grow in value after the first spouse’s death and still pass estate-tax-free to the bypass trust beneficiaries.
  
  
• Property tax benefits. A CST distribution to a child is considered a transfer from the decedent spouse, not the surviving spouse. This distribution can therefore qualify for the decedent spouse’s parent-child property tax reassessment exclusion.

Possible Disadvantages of a CST

There can be potential downsides to creating a credit shelter trust, however:

• Income tax returns must be filed for the CST. Assets that are used to fund the trust can be complicated, so filing returns may difficult and expensive.
  
  
• The tax basis of the assets in a CST is stepped up only once, at the death of the first spouse. With portability, the tax basis would be stepped up again when the second spouse dies.
  
  
• The surviving spouse must be willing to give up some rights and control over the assets. They can generally access all of the trust’s income, and if they are the trustee they can use the principal to pay for health, education and certain other expenses. If someone other than the spouse is named as trustee, the surviving spouse may be able to use some of the trust assets for other reasons, at the discretion of the trustee.