CREDIT SHELTER OR BY-PASS TRUSTS

A credit shelter or by-pass trust can help both you and your spouse take advantage of the estate-tax
credit and transfer up to $3 million in assets to your children or other heirs free of federal estate tax.
 (The amount of assets you and your spouse together can transfer tax free using the estate-tax credit exclusion amount increases to $4 million in 2006–2008 and $7 million in 2009.) To underscore the
value of this planning strategy, see our simplified example, A Case for a Credit Shelter Trust. It shows what can happen when both spouses’ credits aren’t used.

One way to make the most of your and your spouse’s estate-tax credits is to arrange for your estate to
be divided into two parts at your death. One part would pass outright to your spouse. The second part
of your estate is placed in a trust created by your Will. This trust can pay your surviving spouse a lifetime income and then benefit your children or other named beneficiaries after your spouse’s death. You can even give your spouse a limited power to withdraw trust assets. Some people limit the amount in the credit shelter trust to the credit exclusion amount so that any tax on the trust will be offset by the credit.

At your death, your estate-tax credit will be applied against the assets in the credit shelter trust. If those assets are less than or equal to the credit exclusion amount, no estate tax will be due. And no tax is due on the assets passing to your spouse, either, because of the unlimited marital deduction. At your spouse’s death, the credit shelter trust assets will pass to your children or other trust beneficiaries.
The assets won’t be taxed as part of your spouse’s estate. The assets that passed to your spouse
under the unlimited marital deduction will be included in your spouse’s estate. However, your spouse’s credit will be available to offset tax on some or all of those assets.

THE TWO-TRUST ESTATE PLAN

The two-trust estate plan is another planning strategy for couples that uses a credit shelter trust and
one other trust. This plan saves estate tax in the same way a credit shelter trust alone does. But with a two-trust estate plan, the assets that pass to your spouse under the marital deduction are also placed
in a trust, rather than left to your spouse outright. This “marital” trust may be a QTIP trust
(explained later), or it can be another trust qualifying for the marital deduction.

You may give your spouse a lifetime power to distribute trust property, or you can give your spouse the power to distribute property only by Will. Other types of marital trusts also may be used along with the credit shelter trust.


A CASE FOR A CREDIT SHELTER TRUST

When Gordon died, he had a taxable estate of $2.5 million which he left to his wife, Katherine.
His estate paid no federal estate tax because of the unlimited marital deduction. Gordon’s estate-tax credit wasn’t used. On Katherine’s death in 2007, her taxable estate also is worth $2.5 million.
Because Katherine didn’t marry again, the marital deduction is unavailable to her estate. Katherine’s estate claims an estate-tax credit, but this credit effectively exempts only $2 million of her property from tax. Katherine’s estate is subject to an estate tax of $225,000. Using a credit shelter trust in Gordon’s estate plan could have eliminated the tax on Katherine’s estate.

PLANNING FOR 2010

While these trust strategies will help save estate taxes before repeal takes effect in 2010, will they still
be beneficial after repeal? It depends. Most trust strategies do more than save taxes — they also ensure that estate assets will be managed carefully for the beneficiaries’ financial security. And family issues may make trusts the most beneficial way to transfer an estate. Moreover, unless Congress acts, repeal may only be effective for 2010. Clearly, continuing professional guidance is essential.

LIFE INSURANCE

Life insurance plays a part in most estate plans. Make sure you have sufficient coverage on your life for family members to maintain their current lifestyle after you’re gone. For larger estates that may be
subject to tax even when family trusts are used, life insurance can provide the funds needed to pay
estate taxes without liquidating estate assets.

If you have a substantial amount of life insurance, you may want to create an irrevocable life insurance trust to help beneficiaries manage the proceeds and potentially reduce estate taxes.

LIFETIME GIFTS TO FAMILY AND FRIENDS

You don’t have to wait until your death to make tax-saving transfers. In fact, a well-planned program of lifetime gifts to family, friends, and charity can save estate and gift taxes, preserve more of your assets
for your family and other heirs, and ensure your property goes to the people you want to have it.

The Gift-tax Annual Exclusion.

Each year, you can give any number of people up to $11,000 each in assets ($22,000 if your spouse joins in the gift) without triggering any federal transfer tax — gift, estate, or generation-skipping. This annual tax exclusion is available in addition to your gift-tax credit exclusion amount and is adjusted for inflation.

Suppose you make annual gifts of $11,000 to each of your three children and seven grandchildren.
Over a five-year period, you can give them $550,000 tax free. Having your spouse join in your gifts will raise your tax-free gift total over five years to $1.1 million and reduce the assets includable in your estate for estate-tax purposes by $1.1 million — or more if the assets appreciate between the time you make the gifts and your death.

As estate-tax repeal draws near, you also may want to consider lifetime giving strategies that use the
gift-tax annual exclusion and unlimited marital deduction to help family members make the most of the new $1.3 million step-up available to all estates in 2010. If your mother, for example, has a small estate relative to yours, consider using the gift-tax annual exclusion to transfer appreciated assets to her so
that her estate can eventually allocate the basis step-up to the assets before passing the assets back
to you. Note that you must make the transfer more than three years before your mother’s death.

You can use a similar strategy if your spouse’s estate is not large enough to fully use the $4.3 million basis step-up available to surviving spouses. Here, the unlimited marital deduction would allow you to make your transfer all at once without any gift-tax consequences, and the three-year rule wouldn’t apply (since it doesn’t apply to spousal transfers).

Before choosing assets to give, talk with us. We can help you weigh the potential estate-tax savings against possible capital gains tax (discussed previously) so that you can provide your family with the greatest after-tax benefit.

Exclusion for Medical and Tuition Payments.

The tax law also allows you an unlimited exclusion for certain tuition and medical payments made on behalf of others. To qualify for this exclusion, you must make the tuition or medical payments directly to the educational institution or medical facility. Payments for medical insurance qualify for the exclusion. Payments for dormitory fees, books, supplies, and similar school expenses do not qualify for the exclusion.

Gifts to Minors Trusts.

Many people don’t feel comfortable giving large sums to children or grandchildren. A living trust that
will hold and manage those sums until the child is more mature may seem like a good idea. However, gifts of “future interests” (gifts the recipient isn’t able to use or enjoy until some time in the future) don’t qualify for the annual exclusion. Gift tax is imposed regardless of the amount of the gift.

A better strategy is to create a gifts to minors trust. Gifts to these trusts qualify for the annual exclusion. With a gifts to minors trust, you direct your trustee to use the trust income and assets for the child’s benefit — to finance his or her college education, for instance — until the child reaches age 21. Then,
the child must be given the right to all the trust income and assets. However, you can incorporate Crummey powers in the gifts to minors trust that will give the child only a limited time to withdraw from the trust when he or she reaches age 21.


CHARITABLE GIFTS

Making charitable gifts during your lifetime or at your death can help reduce estate taxes. You can make these gifts either outright or in a charitable trust. If you make a charitable gift in your Will, your estate can claim an estate-tax deduction for the value of that gift.

But, rather than waiting until your death, you may want to consider making your charitable gifts now. Lifetime gifts to qualified charities can provide income-, gift-, and estate-tax savings, as well as help further the work of organizations you believe in. Using a charitable trust to make lifetime gifts can give
you a current income-tax deduction in addition to removing assets from your taxable estate.

Charitable Remainder Trusts.

With a charitable remainder trust, you transfer property to a trust set up for the charity of your choice.
The trust pays you, you and your spouse, or someone else you’ve chosen an income for life or a period of years. The trust ends at the death of the last income beneficiary (or earlier if that’s what the trust specified), and the charity receives the property.

Charitable remainder trusts may have another advantage after the estate-tax repeal. A charitable remainder trust funded with appreciated low-basis property allows the trust beneficiary to benefit from
the trust’s sale of the property without paying capital gains tax. Replacing the value of the property given to charity with insurance payable to a family member or other loved one would allow you to make a tax-advantaged gift to charity without “shortchanging” your family or passing along a high capital gains tax liability.

Charitable Lead Trusts.

If you are currently making regular gifts to a favorite charity — or would like to make regular gifts to a charity — you may find it to your advantage to use a charitable lead trust for those gifts. A charitable lead trust pays income to the charity of your choice for a set period. At the end of that period, the trust assets pass to the person you’ve named as the trust’s remainder beneficiary — your child or grandchild, for instance. Again, both the charity and your heirs benefit.