Tusts in Estate Planning-Testamentary Trust

USE OF TRUSTS IN ESTATE PLANNING

WHY CREATE A TESTAMENTARY TRUST?
BY
MICHAEL J. LOMBARDO, ESQ.

People often ask whether a trust should be part of an estate plan. In this article, we will explore various types of Testamentary Trusts and under what circumstances a particular type of Testamentary Trust might play a role in an estate plan. If you do not have a general familiarity with trusts, you should read the article Use of Trusts in Estate Planning-What Is A Trust? before reading this article. If you are interested in learning about Intervivos Trusts, please see the article Use of Trusts in Estate Planning-Why Create A Revocable Grantor Intervivos Trust?

WHAT IS A TESTAMENTARY TRUST?

A Testamentary Trust is a trust included in a person’s Will. The Will may contain more than on Testamentary Trust. The trust does not become effective until the person making the Will dies and assets from the estate are transferred to the trust (i.e. the trust becomes funded). The Will includes the wishes of the person making the Will as to how the trust income and assets are to be distributed. The Will also contains provisions designating the person who is to carry out those wishes, who is called a “Trustee”) and the powers of the Trustee.

Once a person dies, assets do not automatically go into the trust. After the death of the person who made the Will, the estate must be administered. As part of the administration of the estate, assets are transferred to the trust created under the Will for the beneficiaries of the trust.

WHY USE A TESTAMENTARY TRUST?

There may be many reasons to use a Testamentary Trust. Some of the more common types of Testamentary Trusts and the circumstances under which they are used are as follows:

TRUST FOR SURVIVING SPOUSE

A trust set up for a spouse in a Will can be referred to as either a Marital Deduction Trust or a Credit Shelter Trust. Each type of trust serves a different purpose.

Marital Deduction Trust.

A Marital Deduction Trust is a trust set up for the benefit of a surviving spouse with the intent that the assets used to fund the trust will qualify for the marital deduction on the decedent’s estate tax return.

What is the “Marital Deduction”?

Before discussing what a Marital Deduction Trust is and how it is used, it is helpful to have an understanding of what we mean by “Marital Deduction”. When we refer to the “Marital Deduction”, we are referring to the deduction that is permitted to be taken by an estate on the estate tax return of the decedent for assets passing to a surviving spouse of the decedent so that assets passing to the surviving spouse are not subject to estate tax in the estate of the decedent.

Whether a person is a “spouse” at the time of the decedent’s death will be determined under State law. For example, a couple who entered into a valid marriage recognized under New York law may be living apart but yet still be considered married so that upon the death of the decedent the other party to the marriage may be considered a spouse. Whether a person is considered a spouse will have to be determined from the facts surrounding the marriage and any separation of living arrangements by the couple at the time of the decedent’s death.

The marital deduction is available for Federal and New York estate tax purposes to an estate of a US citizen, resident alien and non-resident alien for assets “passing” to a surviving spouse who is a US citizen. If the surviving spouse is not a US citizen, the marital deduction may be available but only in limited circumstances. Assets passing to the surviving spouse that are to be included in the marital deduction are listed on Schedule M of the decedent’s estate tax return.

Once a determination is made that a person is considered a “spouse”, a determination needs to be made as whether assets are “passing” to the surviving spouse. There are many ways assets can “pass” to a spouse, some of which are as follows:

Outright through the Decedent's Will.

Outside of the Will under survivorship rights for property held as tenants by the entirety by the decedent and surviving spouse (i.e. held as husband and wife) or as joint tenants with a right of survivorship

Outside of the Will as a named beneficiary of an interest in an asset of the decedent (such as a life insurance policy or Individual Retirement Account)

the Will or through an trust created during the decedent’s lifetime as Qualified Terminable Interest Property (also known as a Q-TIP) Trust for which an election has been made by the executor of under the decedent’s Will.

How can a Marital Deduction Trust provide for A Marital Deduction?

Assuming that there is no issue that a person is a surviving spouse of the decedent at the time of the decedent’s death, a Marital Deduction Trust is a trust that if structured properly allows the estate of the decedent to take a deduction on the estate tax return for the value of the assets used to fund the trust so that the estate tax treatment is the same as if the assets were transferred directly to the surviving spouse. This allows the value of the assets used to fund the Marital Deduction Trust to escape estate taxation in the estate of the spouse who is first to die.

Why use a Marital Deduction Trust instead of a direct transfer to a spouse?

A Marital Deduction Trust is a trust that is commonly used in circumstances where the person making the Will believes a spouse may need some assistance in handling his or her financial affairs. It may also be used where the decedent desires to allow the surviving spouse (including a situation where the surviving spouse may be from a second marriage) to have the benefits of the assets of the decedent’s estate, but upon the death of the surviving spouse, provide how the assets not used by the surviving spouse are distributed, such as to the children of the decedent.

A Marital Deduction Trust allows assets to pass through the decedent’s estate without being subjected to estate taxes in the decedent’s estate with all of the benefits as if the assets were given to the surviving spouse outright (thus the name “Marital Deduction”). However, use of a Marital Deduction Trust allows more control over the use of the assets that are used to fund the trust. A Marital Deduction Trust allows the Trustee to use some discretion in how the assets are used, yet making provisions to ensure that the income generated from the trust is utilized for the benefit of the spouse. Some characteristics of a Marital Deduction Trust include the following:

Distribution of all income to the surviving spouse at least annually

Discretionary distribution of the trust assets for the health, maintenance and benefit of the surviving spouse.

Manner in which the assets of the Trust will be distributed following the death of the surviving spouse.

Are there any disadvantages to using a Marital Deduction Trust?

The main disadvantage of a Marital Deduction Trust is that the assets remaining in the Marital Deduction Trust upon the death of the surviving spouse will be included in the estate of the surviving spouse. This is no different than had the assets been transferred outright to the surviving spouse either through the decedent’s Will or through some other means outside of the Will.

Credit Shelter Trust

A “Credit Shelter Trust” is a trust that serves a function that is opposite to the function of a Marital Deduction Trust. As noted above, the purpose of a Marital Deduction Trust is to allow assets to pass for the use of the surviving spouse without subjecting those assets to estate tax. In a Credit Shelter Trust, the desire is to maximize the amount of the unified credit against estate tax.

What is the “Unified Credit”?

The Federal unified credit against estate tax in 2023 is equivalent to passing assets having a total value of $12,920,000 to beneficiaries (excluding the value of assets passing to a surviving spouse) either under the Will or outside of the Will. This amount currently is scheduled to be reduced to $5,490,000 for tax years 2026 and after. Under New York law, the amount that can be passed to beneficiaries (excluding the value of assets passing to a surviving spouse) either through the Will or outside of the Will is $6,580,000.

How does the Credit Shelter Trust use the “Unified Credit”?

As noted above, assets that are to be included in the marital deduction are to be designated by the executor on Schedule M of the estate tax return when it is filed. If the executor does not elect to include in the marital deduction the assets used to fund the Credit Shelter Trust, then the values of the assets used to fund the Credit Shelter Trust will not be included in calculating marital deduction. This is the purpose of using a Credit Shelter Trust so that the assets used to fund the Credit Shelter Trust will be “taxed” in the decedent’s estate and when the surviving spouse dies, the assets left in the Credit Shelter Trust will not be included in the estate of the surviving spouse. This allows the maximum use of the unified credit against estate tax. However, in order for a trust to qualify as a Credit Shelter Trust so that the assets remaining in the Credit Shelter Trust following the death of the surviving spouse escape being taxed in the estate of the surviving spouse, the surviving spouse must have limited control over the assets used to fund the trust. The failure to provide for these limitations could result in the inclusion of the assets used to fund Credit Shelter Trust in the estate of the surviving spouse upon the surviving spouse’s death.

How is the Credit Shelter Trust structured?

The typical Credit Shelter Trust provides for the surviving spouse to be the beneficiary during the surviving spouse’s lifetime, and the children and/or grandchildren are usually the beneficiaries who will receive what is left in the Credit Shelter Trust upon the death of the surviving spouse. Following the death of the surviving spouse, depending on the trust language, the Credit Shelter Trust can continue as a trust for the beneficiaries who follow the surviving spouse (called remainder beneficiaries) or there can be direct distribution of the assets to the remainder beneficiaries.

TRUST FOR CHILDREN OR GRANDCHILDREN

Sometimes the person making a Will would like to make a provision for children or grandchildren (whether or not there is a surviving spouse). However, there is a concern that if the beneficiary is a minor or is of a young age, the assets may be squandered if passed directly to the beneficiary without any controls. One common method for providing for beneficiaries where there is this concern is to set up a trust. The trust usually provides that the income can either be accumulated or distributed to or for the beneficiary (for things like tuition for college) until the beneficiary reaches a certain age at which time a portion of the trust assets will be distributed outright to the beneficiary to be used as the beneficiary desires. The trust continues in this manner and at certain age levels the balance of the trust assets are distributed. For example, the trust may provide that the income and assets of the trust be used for a child (including education expenses) until the child reaches age 25 at which time 1/3 of the assets will be distributed to the child outright, and the trust will continue in this manner and provide for a distribution of assets when the child reaches age 30 with a final distribution when the child reaches age 35.

The value of the assets used to fund a trust for the benefit of a child or grandchildren will be counted toward the unified credit equivalent and may affect how much should be used to fund a Credit Shelter Trust if there is a surviving spouse. Also, if the beneficiary is a grandchild or more remote descendant, there may be an additional tax imposed called the Generation Skipping Tax. This is an issue that should be discussed with your attorney to see if the Generation Skipping Tax will apply.

CAUTION: THIS ARTICLE IS INTENDED TO PRESENT GENERAL INFORMATION AND IS NOT INTENDED TO BE A SUBSTITUTE FOR CONSULTATION WITH LEGAL COUNSEL.

IRS CIRCULAR 230 Disclosure: To ensure compliance with requirements imposed by the IRS, please be aware that any U.S. federal tax advice contained in this communication (including any attachments or enclosures) is not intended or written to be used and cannot be used for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or (ii) promoting, marketing or recommending to any other person any transaction or matter addressed herein.

Last Update: January 1, 2023