Using Testamentary Trusts: Part One-Tax Based Trusts

Property that passes under a Last Will and Testament is distributed in two distinct manners.  For those with minimal assets and concerns regarding taxes, asset protection and waste, an outright transfer of property is simplest and most efficient way to pass property.  But, in most situations, concerns about protecting the testamentary assets leads to the use of trusts established under the Will known as testamentary trusts.

Testamentary trusts come in two forms: trusts that are structured to delay, minimize or eliminate estate taxes and trusts used to protect the underlying assets from waste by a minor or disabled beneficiary.  Next week, I will discuss the latter type of testamentary trust.  Today, we look at the three main types of tax based testamentary trusts used by estate planners.

Marital Trust-The most common form of tax-based trust is established to take advantage of the federal and New York state marital deduction for estate tax purposes.  Under the laws of both the state and federal estate tax system, unlimited assets may be passed to a surviving spouse without incurring an estate tax.  Upon the death of the surviving spouse, the assets in a marital trust are treated as part of the surviving spouse’s taxable estate.

Marital trusts can be structured to provide the surviving spouse with a lifetime income interest as well as the ability to receive principal distributions.  Beyond tax savings, a marital trust can ensure that the assets in the Trust will be transferred to your children and not to any subsequent spouse if your spouse remarries.

Unlike the other testamentary trusts mentioned in this post, same-sex couples for New York estate tax purposes can now utilize a marital trust.  However, it should be noted that assets in a marital trust for a same-sex couple would be subject to federal estate tax under current federal law.

Credit-Shelter Trust-A distinct disadvantage of a marital trust is that the assets in a marital trust are subject to estate taxes after a surviving spouse passes.  For individuals and couples with assets in excess of the current estate tax exemption, it is possible to preserve a portion of their assets from estate tax even after the surviving spouse passes.  This is accomplished by using a credit-shelter trust.

A credit-shelter trust is funded with a portion of a decedent’s estate up to the federal or New York state estate tax exemption.  The surviving spouse receives the income generated by the trust property for their lifetime and can also receive principal distributions for their health, education, maintenance and support.  A decedent’s children may also be beneficiaries of the trust.

Upon the death of the surviving spouse, the remaining assets in the trust pass federal estate tax-free.  However, if the federal exemption were used, New York state estate tax would be due.  A secondary disadvantage is that utilizing a credit-shelter trust removes a certain amount of flexibility and therefore, it is not always the ideal strategy for individuals who have estates below the federal estate tax exemption.

Disclaimer Trust-For individuals and couples with assets below the federal estate tax exemption, it is likely that their estate planning will focus on funding a marital trust.  In some circumstances, assets can grow between the time an estate plan is enacted and the date the first spouse passes.  Even if a credit-shelter trust is not mandated under a will, using a disclaimer trust can allow a surviving spouse to receive similar benefits.

A disclaimer is a post-mortem (after death) planning technique by which a surviving spouse renounces some or all of their inheritance.  If a disclaimer trust were included in a will, the disclaimed assets would pass as if the surviving spouse had predeceased and the disclaimed assets would fund the disclaimer trust.

Assets held inside a disclaimer trust will pass estate tax-free upon the death of a surviving spouse.  The benefit of using a disclaimer trust over a credit shelter trust is that it allows the surviving spouse flexibility in deciding whether to preserve certain assets and shelter them from estate taxes after they die.   The disadvantage is that funding a disclaimer trust requires an affirmative step by the surviving spouse and additional paperwork will be required.

The use of tax-based trusts under a will allows a surviving spouse the benefit of their spouse’s assets while also preserving the maximum amount of those assets from excess taxation.  This benefit, coupled with the traditional benefit of using a testamentary trust, makes having one or more of these trusts included in your Will a very smart idea.

Please contact info@levyestatelaw.com for more information about testamentary trusts.

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