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Gimme Shelter: Income Tax Planning Opportunity for Certain Credit Shelter Trusts

Lerch Early Legal Update

For years, estate tax planning for couples has included the use of credit shelter trusts, also known as bypass or family trusts, to take advantage of the first-to-die spouse’s estate tax exemption. Over the past 15 years, the federal estate tax exemption has increased from $675,000 to $5.4 million in 2015. Maryland and the District of Columbia have passed laws increasing their state estate tax exemption amounts. The increase in federal and state estate tax exemptions has meant estate taxes are no longer a concern for most people.

This presents a potential adverse tax situation for a surviving spouse who is a beneficiary of a credit shelter trust created at the death of the first spouse, and whose assets are below the federal and state tax exemption amounts. At the death of the surviving spouse, the assets remaining in a credit shelter trust will not receive a step-up in basis, but will have a carryover basis equal to the value of the assets at the death of the first spouse.

How is a Step-up, a Step-down, or a Carryover Basis Determined?

It is important to understand what a “step-up” or a “step-down” in basis means for income tax purposes. The general rule for a property includable in a decedent’s taxable estate is that the beneficiary who receives the property has a tax basis (e.g., costs from which an increase in value is later taxed) that equals the fair market value of the property when the decedent dies. This means the property in the hands of the beneficiary receives either a step-up or a step-down in basis. For example, if the decedent owned real property with a basis of $30 and a fair market value of $50 at his/her death, then the basis in the hands of the beneficiary would be $50.

The alternative is called “carryover basis,” in which the beneficiary would hold the property with the same basis as the decedent. For example, if someone gifts you property with a basis of $30 and a fair market value of $50, you will hold the property with a basis of $30. You will not necessarily receive a step-up in basis for assets held in a trust at the death of a beneficiary. The assets in the trust must be includable in the trust beneficiary’s taxable estate for those assets to receive a basis adjustment.

Evaluate Capital Gains Tax Exposure Before Selling Property Received in Credit Shelter Trust

There could be significant capital gains tax exposure at the eventual sale of property held in the credit shelter trust after the surviving spouse’s death. One way to alleviate the capital gains tax exposure is to bring the assets back into the taxable estate of the surviving spouse to obtain a step-up in basis upon the death of the surviving spouse. However, before embarking on this strategy, experienced counsel should be consulted to do an analysis of the income and estate tax issues, and review the trust and the legal issues relative to implementing the plan. Recent increases in estate tax exemptions – while good news for estate beneficiaries – can have unintended adverse effects on a credit shelter trust drafted when these exemptions were much smaller.

Will Hellams is an estate planning attorney who regularly works with individuals and families on strategies to reduce transfer taxation, protect and preserve assets, and facilitate the transfer of assets among family members. For more information on credit shelter trusts, contact Will at (301) 841-3843 or jwhellams@lerchearly.com.

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This content is for your information only and is not intended to constitute legal advice. Please consult your attorney before acting on any information contained here.

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