Planning for Couples With Net Worth Between $5 Million and $10 Million

A New Look for a Familiar Face

By Lori Parker, Esq.

With a few skillful adjustments, credit shelter trusts are still an estate planning tool that should be considered.

Like well-worn slippers or a favorite armchair, credit shelter trusts (CSTs) have been reliable and familiar estate planning methods for couples whose assets are substantial — for purposes of this article, defined as between $5 million to $10 million. Gather the specifics, name the trustee, and generate the documents — and voila — an estate plan is born!

With the grand entrance of portability, linked arm-in-arm with the indexed $5.34 million (the number for 2014) gift, estate, and GST tax exemptions, CSTs may look dowdy by comparison. After all, with the $5 million exemption, inflation indexing, and portability, the estate tax probably won’t touch these clients … right?

Credit Shelter Trusts

But it’s not time to scrap CSTs. If anything, the recent federal changes have increased, not decreased, the complexity of planning for estates in the $5 million to $10 million range. Put differently, portability and the $5.34 million exemption offer creative estate planners an opportunity to give the CST a makeover.

A good makeover begins by taking stock of the known positives and then accentuating them. For the CST, those assets include:

• Ensuring responsible asset management by the surviving spouse;
• Passing assets to children of the marriage, while also accommodating the surviving spouse’s need for financial support
• Preventing, in the event that the surviving spouse remarries and predeceases the new spouse, the transfer of assets to the new spouse;
• Shielding both husband and wife from potential legal liability to creditors.

Of course, these CST benefits come with significant flaws, including high income tax rates and the new 3.8 percent Medicare surtax on trusts’ net investment income. This tax applies even where the trust has minimal undistributed net income — $11,950 and higher.

A skillful makeover uses flaws as the seeds of transformation. For example, an existing CST plan may have included certain gifts — an inclusion solely attributable to avoidance of estate tax. Absent federal estate tax concerns, however, the client may want to reconsider those gifts.

The art of skillful planning can turn this emergent blemish into an opportunity. The new rules offer us the chance to educate clients about new planning options, and to review and revise existing plans consistent with the growing importance of flexibility.

As discussed above, reliance on the generic CST as a primary planning mechanism may have worked in times past — but dependency on that model under the new rules may result in too narrow a focus on federal income tax issues. The “new normal” offers a sleeker, trimmed down profile for CSTs — one that harmonizes their attributes with the $5 million exemption and other planning tools, such as portability.

Portability

The undeniable beauty of the $5 million-plus exemption ought not to distract planners from the exemption’s darker side — a 40 percent tax rate on that portion of an estate that exceeds the exempt amount.

Clients’ whose assets fall between $5 and $10 million need not be vulnerable to this reality, however, when portability is on the scene.

When the first spouse dies, portability allows transfer of the amount of their unused estate tax exclusion to the surviving spouse. The surviving spouse can then use that transferred amount, in addition to their own exclusion, to diminish estate taxes. Portability also offers a second basis step-up at the surviving spouse’s death.

Overreliance on portability is fraught with the same dangers as overreliance on CSTs. Electing portability or disclaiming it is a case-by-case decision, not a ready-made one. For some clients — those who have potential liabilities to creditors and those who have concerns about how the surviving spouse will manage and/or distribute assets — portability comes at too high a price. Where such issues exist, the protections offered by a CST may well outweigh portability’s potential for tax savings.

Once again, artful planning is tailored to fit the client, and requires more than just filling in the blanks. Rather, the planner must engage the client in dialogue about their life circumstances — while employing attentive listening, copious notes, and probing questions. Follow-up conversations may be needed to fully discern the “big picture” of the client’s interwoven financial and family circumstances. In-depth inquiry is foundational to sound planning for substantial estates. Information gleaned from such conversations provides the blueprint for a plan customized to the client’s current and future needs.

Mix-and-Match Planning Options

A. Portability or CST — Surviving Spouse Chooses

If there are no liability or spendthrift issues, a “hybrid” plan can offer maximum flexibility to the surviving spouse. Under this rubric, the surviving spouse makes the choice, after the other spouse’s death, whether to elect or disclaim portability. This offers the surviving spouse the luxury of choice based on the current circumstances. To create a hybrid plan, both members of the couple execute wills with the same provision, leaving all assets to the surviving spouse. If the surviving spouse disclaims portability, however, the will provides that all assets go into a CST.

B. QTIP-CST Combo

A QTIP trust, like a CST, can protect assets from poor financial management and from creditors. The two vehicles, while serving similar purposes, nonetheless have significant distinguishing factors.

One such difference is that the CST is not considered as part of the surviving spouse’s estate. A QTIP, on the other hand, is included — and thus the QTIP is ineffective in sheltering assets from estate tax. This factor has been one of the engines driving the use of CSTs. However, now that the federal exemption is at the $5.34 million mark, planners may view the utility of QTIPs in a new light — particularly so in subsequent-marriage situations. This is so due to the nature of funds accessible to the surviving spouse — another distinction between the CST and the QTIP. Even though funds in the QTIP are part of the surviving spouse’s estate, the spouse has access to only the trust income, not its principal. By contrast, in a CST, the surviving spouse can get to both income and principal.

This setup can be used to entirely separate assets intended for the decedent’s children versus those earmarked to support the surviving spouse. Remarriage and/or blended family situations are ready-made sources of intra-family friction. A plan of this nature — dividing assets into two separate management vehicles for two different sets of beneficiaries’ needs — can pre-emptively manage expectations and emotions that all too often lead parties into court.

To harness the power of a CST paired with a QTIP is a relatively simple endeavor. A master trust with sub-trusts will likely do the job. Under this scenario, assets up to the $5.34 million federal exemption would fund the CST; the remaining assets would flow into the QTIP. Portability, of course, is sacrificed … but since the CST avoids tax at both deaths, and the QTIP has no more than $5 million, the surviving spouse’s estate still avoids the sting of federal estate tax.

Decoupling States

Roughly one-third of the states are decoupled from the federal estate tax changes, and impose estate and/or inheritance taxes. In jurisdictions where the exempt amount for state estate taxes is lower than the federal tax-exempt amount, a plan that maximizes the available federal estate tax exemptions may incur state estate tax on the first spouse’s death. As a result, planners in decoupling states will likely focus on minimizing the state-level tax bite.

Focus on the tax liability at the state level should not, however, be a default position. Planners should strive for flexibility — for a plan that defers choices and allows the surviving spouse to make decisions based on circumstances that exist when the first spouse dies. Such factors include the overall value of the assets, the surviving spouse’s health and life expectancy, and the needs of children and grandchildren. Disclaimers in the client’s will or trust can help to keep options open. Similar to the portability election, disclaimers allow the surviving spouse to determine whether a CST will be funded, and if so, in what amount.

The vast complexities and state-to-state differences associated with decoupling are too deep and murky for exploration in this short article. Suffice it to say that planners in decoupling jurisdictions, prior to considering the matters discussed above, must determine whether state tax minimization or maximization/preservation of basis step-up and favorable trust benefits is of greater priority. A flexibly crafted plan can defer that choice until the first spouse dies, offering the surviving spouse the benefit of planning for the future based on current circumstances.

Conclusion

Portability and the $5.34 million federal estate tax exemption have prompted us to update our approach to CSTs. While that approach is fresh today, planners must remain mindful that both tax laws and clients’ objectives are malleable and subject to change. We must expect the unexpected — and most of us have limited powers to predict the future. With those realities in mind, planning with flexibility is the key — whatever the future might hold.

Lori Parker, Esq., Pittsford, N.Y., is the NAELA Health Care Section Steering Committee Chair.