Choosing the Trusts in Your Estate Plan

There are a number of important issues which every couple must consider when deciding how to structure their estate plan. These include: (i) who will be the trustees; (ii) when should the children have access to the estate when both parents are gone; and (iii) how should the spouses allocate the trust assets and what trusts should be established after the death of the first spouse. There are a number of responses to these questions, and the proper response for each set of clients will be dependent on the unique facts and circumstances of each family. The purpose of this memo is to give clients some general information about their choices in allocating trust assets.

There are three basic legal structures that are commonly used by estate planners, each with some variations.1 Each will be discussed briefly below, with comments on the pros and cons of each. The examples given are useful whether the estate plan is created in a revocable living trust or in a Will; however, if the spouses have Wills, the surviving spouse’s assets will be held in his or her name and not in the Survivor’s Trust as discussed below. Since most estate plans in recent years have been created within the living trust structure, the focus of this memo will be on the division of a living trust for a married couple.

The Three Trust Model

In this model, the trust will direct division of the trust estate after the first death (after payment of administration expenses, taxes, and specific gifts) into three separate trusts, a Credit Shelter Trust2, a Marital Trust and a Survivor’s Trust. Each trust has a different purpose.

  1. The Credit Shelter Trust is intended to be a separate irrevocable trust funded with assets equal in value to the deceased spouse’s remaining estate tax exemption under the tax laws in existence at the date of the deceased spouse’s death. This trust is structured so that its assets will not be included in the estate of the surviving spouse at his or her death. Because the goal of establishing a Credit Shelter Trust is “non‐ inclusion” in the estate of the surviving spouse, the assets in the Credit Shelter Trust do not obtain a second “step up” in income tax basis to fair market value when the surviving spouse dies. The Three Trust Model is intended to assure a married couple that the estate tax exemptions of both of them will be effectively utilized and that the beneficiaries desired by the first spouse to die will receive the assets of the first spouse when the surviving spouse dies. During the lifetime of the surviving spouse, the sole income and principal beneficiary of the Credit Shelter Trust is typically the surviving spouse but may also include the children of the deceased spouse, children of the deceased spouse and the surviving spouse, or a combination of the above. The remainder beneficiaries are set forth in the trust document to receive their shares upon the death of the surviving spouse. To provide flexibility, if desired, the trust may also give the surviving spouse a “limited power of appointment” to alter the beneficiaries of the Credit Shelter Trust at his or her death, among specific individuals or a broad class of individuals. If the surviving spouse is the trustee of the Credit Shelter Trust, the criteria for discretionary distributions of income or principal are limited to the health, education, support and maintenance of the beneficiaries (the so‐called HEMS) standard. In addition to its use to protect the first spouse’s estate tax exemption, the Credit Shelter Trust can be a valuable vehicle to utilize the deceased spouse’s generation‐ skipping transfer tax (GST)3 exemption. With the proper election made on the estate tax return of the deceased spouse, this would allow the assets of the Credit Shelter Trust to be “GST exempt,” and eventually pass to trusts for children and grandchildren (or other persons) for multiple generations without incurring any estate or GST tax (irrespective of any growth in the value of the trust assets). This can be accomplished even if the surviving spouse is the initial lifetime beneficiary of the Credit Shelter Trust.
  2. The Marital Trust is intended to be a second separate irrevocable trust funded with assets equal in value to the balance of the deceased spouse’s interest in the trust after creation and funding of the Credit Shelter Trust. Pursuant to the applicable Internal Revenue Code sections, the Marital Trust is required to be administered for the sole benefit of the surviving spouse during his or her lifetime, with annual net income distributions to the surviving spouse being mandatory. The clients also have the option of providing principal distributions to the surviving spouse should he or she need them but such a provision is not mandatory. The primary purpose of the Marital Trust is to defer estate tax on its assets until the death of the surviving spouse and to permit the deceased spouse to, again, name the remainder beneficiaries. There are a number of rules associated with the establishment of a Marital Trust, such as (i) the spouse must have the power to make unproductive assets productive; (ii) undistributed income at death of the surviving spouse must either be paid to the surviving spouse’s estate or subject to a power of appointment in the surviving spouse at death; (iii) an election to claim the estate tax marital deduction must be made on the deceased spouse’s timely filed estate tax return. As with the Credit Shelter Trust, to add flexibility on the surviving spouse’s death, the surviving spouse may be given a “limited power of appointment” to alter the ultimate beneficiaries of the Marital Trust, among specific individuals or a broad class of individuals. The assets remaining in the Marital Trust at the death of the surviving spouse are includable in the surviving spouse’s taxable estate, and will receive a step up in income tax basis equal to the fair market value of the assets at the death of the surviving spouse. The Marital Trust can also be a valuable tool to receive the balance of the deceased spouse’s unused GST exemption to the extent that his or her GST exemption exceeds the amount of assets that can be allocated to the Credit Shelter Trust.
  3. The Survivor's Trust consists of the surviving spouse’s interest in the living trust. As such the surviving spouse has complete control over both income and principal distributions from the Survivor’s Trust, including the power to modify, amend, restate or revoke the trust. The assets of the Survivor’s Trust, together with the assets of the Marital Trust, are included in the surviving spouse’s taxable estate at his or her death, subject to the remaining estate tax and GST tax exemptions of the surviving spouse. The surviving spouse can, if desired, structure the disposition of the Survivor’s Trust to add assets equal to his or her remaining GST exemption to the exempt trusts created for children (or other persons) by the first spouse.
  4.  Pros and Cons.
  • After the death of the deceased spouse, the Three Trust Model will require separate tax identification numbers and separate tax returns annually for the Credit Shelter Trust and the Marital Trust. The Survivor’s Trust reports under the surviving spouse’s social security number.
  • The Three Trust Model will require an election on the deceased spouse’s timely filed estate tax return to claim the estate tax Marital Deduction.
  • The Three Trust Model is very effective for families where either one or both spouses have children by previous marriages so that each spouse can structure his or her estate plan to provide certainty that the spouse’s children will receive their parent’s estate on the death of the surviving spouse.
  • The Marital Trust and Credit Shelter Trust both lack a certain flexibility to permit the surviving spouse to deal with changed circumstances which were unforeseen when the trust was created; however, the use of a limited power of appointment in the surviving spouse can to some extent remedy that problem, if adding the limited power is appropriate under the circumstances.
  • The creation of the Credit Shelter Trust makes it convenient to utilize the first decedent’s GST exemption for that trust.
  • All assets held in the Credit Shelter Trust at the death of the surviving spouse, including all growth, appreciation and accumulations within that trust, will escape estate tax at the death of the surviving spouse.

The Two Trust Model

In this model, the trust estate is divided into a Credit Shelter Trust and a Survivor’s Trust – the Marital Trust is eliminated.

  1. The Credit Shelter Trust is an irrevocable trust that serves the same purposes as set forth above in the Three Trust Model, i.e., it provides certainty that the remaining estate tax exemption of both spouses will be utilized effectively and that the assets of the Credit Shelter Trust are not includable in the estate of the surviving spouse. As with the Three Trust Model, the assets in the Credit Shelter Trust do not receive a step up in basis on the death of the surviving spouse. Consistent with the comments in Part I above, the Credit Shelter Trust is a convenient vehicle for use of the deceased spouse’s GST exemption.
  2. The Survivor’s Trust. This model will consist of the remaining assets of the trust estate, including the balance of the assets belonging to the deceased spouse after the Credit Shelter Trust is funded, and the assets belonging to the surviving spouse. The surviving spouse has total control over the assets in the Survivor’s Trust, including the power to make gifts from, modify, amend, restate or revoke the Survivor’s Trust. The assets of the Survivor’s Trust are subject to inclusion in the surviving spouse’s estate for federal estate tax purposes, and the estate tax will be calculated using the surviving spouse’s remaining estate tax exemption. The Survivor’s Trust assets receive a step up in basis to fair market value on the death of the surviving spouse.
  3. Pros and Cons.
  • With the creation of only one irrevocable trust in the Two Trust Model, after the death of the deceased spouse, only the Credit Shelter Trust will be required to obtain a separate tax identification number and file a separate income tax return. The Survivor’s Trust reports under the surviving spouse’s social security number.
  • The surviving spouse has total flexibility with respect to changes to the Survivor’s Trust. This can be beneficial when circumstances change because it allows the surviving spouse to modify the disposition of the assets of the Survivor’s Trust to deal with unforeseen circumstances. However, it also remains a powerful tool in the hands of the surviving spouse when there are issues of family dissension already in play.
  • If the unused GST exemption of the first spouse to die exceeds the amount that can be allocated to the Credit Shelter Trust, it may be lost without the use of the Marital Trust.
  • The Two Trust model is often recommended when the nuclear family consists of spouses and children who are the issue of both spouses.

The Portability Model

The Portability Model has only recently been recognized by the Internal Revenue Code (the “Code”). Code Sections 2010(c)(4) and (5) were first made effective for estates of decedents dying after 12/31/2010. It permits a married couple to structure their estate plan by allocating all of the first decedent’s assets to the surviving spouse or to the Survivor’s Trust but not thereby forgo the use of the first decedent’s remaining estate tax exemption. This choice allows the surviving spouse to utilize both his or her estate tax exemption and the estate tax exemption of the deceased spouse when making gifts and when calculating the estate tax in the estate of the surviving spouse. If the couple wishes to structure their estate plan in this fashion, the following rules apply:

  1. The transfer of the “deceased spouse’s unused exclusion amount” (DSUEA) must be elected on a timely filed, complete and properly prepared, estate tax return for the deceased spouse filed by the deceased spouse’s executor or trustee.
  2. The normal statute of limitations which might otherwise apply to the deceased spouse’s estate tax return does not apply to a return electing DSUEA. This allows IRS examination of the DSUEA later, including on the death of the surviving spouse, in connection with the application of his or her estate tax exemption.
  3. The surviving spouse may only utilize the DSUEA of a predeceased spouse if the predeceased spouse in question was the last predeceased spouse of the surviving spouse and portability was elected at the time of death of that deceased spouse. The issue of potential remarriage is an important part of the discussion as to whether Portability is appropriate.
  4. The rules respecting the applicable exclusion amount of a surviving spouse who has utilized his or her predeceased spouse’s DSUEA and then remarried a second (or third) spouse who dies also electing to utilize DSUEA are complex and intended to limit the amount of exemption passing to the surviving spouse.
  5. Pros and Cons.
  • The election of Portability will provide the surviving spouse’s estate with a step up in income tax basis to fair market value on one hundred percent of the assets at the survivor’s death.
  • Potential remarriage and potential loss of the DSUEA may lead to a reluctance to elect DSUEA, particularly when the exemption of a wealthy deceased spouse has been little utilized during that spouse’s lifetime. The tax situation of the surviving spouse if he or she were the beneficiary of a Credit Shelter Trust may have less risk.
  • The Portability Model puts the surviving spouse in full control of the estate of the deceased spouse (and his or her exemption) as well as that of the surviving spouse. This model is only recommended when both spouses fully understand its implications.
  • All growth and appreciation on the assets which might otherwise have been allocated to the Credit Shelter Trust will be included in the surviving spouse’s estate and subject to estate tax. Substantial growth in the value of assets after the first death could lead to a higher overall estate tax at the death of the surviving spouse notwithstanding the availability of the estate tax exemptions of both spouses.
  • While Portability is an attractive method to simplify the estate plan, get a full step up in income tax basis, and permit the surviving spouse to use both spouses’ estate tax exemptions, the election of Portability does not permit the surviving spouse to utilize any GST exemption of the deceased spouse. There is no portability of GST exemption, and therefore the deceased spouse’s unused GST exemption will simply be lost. If it is the goal of both spouses to maximize the use of their GST exemptions and to create fully funded GST exempt trusts for children, grandchildren or other persons which can pass to several generations without estate and GST taxes, Portability would not be recommended.

1 This memorandum does not address the separate issues when the surviving spouse is not a U.S. citizen and a Qualified Domestic Trust must be considered.

2 This memo does not discuss the manner of funding of these trusts, such as by pecuniary formula or fractional division. Each may have a slightly different outcome but the most important question is whether the three trust model is the most appropriate for the family in question.

3 This article does not fully explore Chapter 13 of the Code which contains the provisions for administration and collection of the GST. However a brief explanation is appropriate so that the terminology respecting GST in the article is clear. Subject to the generation‐skipping transfer tax exemption provided to each taxpayer for use during lifetime or death (which exemption is the same amount as the estate and gift tax exemption), assets passing by gift or inheritance to persons (or trusts with younger generation beneficiaries) who are two or more generations below the transferor (a decedent or a donor) incur a separate transfer tax known as GST tax equal to the maximum estate and gift tax rate.

For any additional questions, please contact Mimi Golbert (310‐282‐6234) or Lori Livingston (310‐282‐6210).