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When it comes to paying federal estate taxes, the law shows great respect
for the institution of marriage. Each spouse has an “unlimited marital
deduction.” This permits one spouse to leave all of his/her assets in any
amount to the surviving spouse without paying a dime in federal estate
taxes.
    However the “unlimited marital deduction” does not avoid the eventual
payment of federal estate taxes. It simply defers payment until the
surviving spouse dies. At that time, all of the surviving spouse’s assets
(including those inherited from his/her spouse) will be subject to federal
estate tax at tax rates that start at 18% and go as high as 49%.
    Assume that George Smith and his wife, Annette, have combined assets
worth $4 million dollars (family house, pension, life insurance, stocks,
bonds, etc.). Assume that George has $2 million in assets in his name and
Annette has $2 million in assets in her name. George’s Will leaves all of his
assets to Annette and Annette’s Will leaves all of her assets to George.
    When George dies, Annette inherits George’s $2 million without paying
any federal estate tax due to the “unlimited marital deduction.” In
combination with her own $1.5 million in assets, Annette’s assets now total
the full $4 million.
    Annette now wishes to leave her $4 million estate to the Smith children.
However her $4 million estate will be subject to a federal estate tax of $1.9
million. If she has no federal estate tax credit to reduce this tax bill, her $4
million estate will shrink to $2.1 million – a staggering 48 % reduction to
her children’s inheritance.
    Although federal estate tax rates are exorbitant, Uncle Sam does permit
every
person to offset the federal estate tax on $2 million in assets.
    If Annette’s full $2 million federal estate tax exemption is still available
to her (there are ways she could have used up all or part of it during her
lifetime), her taxable estate will shrink from $4 million to $2 million and
reduce her federal estate tax from $1.9 million to $800,000. While this
enables the Smith children to receive more of their mother’s $4 million
estate, Uncle Sam will still claim $800,000 in the form of federal estate
taxes.
    If George and Annette each had prepared a Credit Shelter Trust,
however, the Smith children would have inherited the entire $4 million in
assets without paying any federal estate taxes. Simultaneously, Annette
would have had the benefit of the income generated by the Trust for the
rest of her life.
    With proper planning, the Credit Shelter Trust can eliminate all federal
estate taxes for married couples with combined assets up to $4 million, and
substantially reduce federal estate taxes for married couples with assets in
excess of $4 million.
    A “trust” is simply a different way to hold assets. When funds are placed
into a trust, a “trustee” manages the funds on behalf of “beneficiaries” who
eventually receive the trust funds. Each year, the trust funds generate
interest income that the trustee pays to persons designated by the trust.
    Assume that George’s Will contains a Credit Shelter Trust. Upon his
death, George’s $2 million in assets do not go directly to Annette. Instead,
his assets flow into the Credit Shelter Trust. Under the terms of the trust,
the assets are invested and the income generated from those assets are
paid to Annette for as long as she lives. If the income from the trust is
insufficient in a given year, Annette can withdraw funds directly from the
trust in order to maintain her lifestyle. Upon her death, the trust ends and
the proceeds pass to the Smith children.
    Since George can exempt $2 million from federal estate tax, his date-of-
death transfer of $2 million into the trust incurs no federal estate tax.
Although Annette does not gain full control of her husband’s assets, she is
able to withdraw trust assets if she needs them, and she does receive the
income generated by the trust for as long as she lives. Upon her death, the
trust terminates and George’s $2 million in assets pass to the Smith
children without paying any federal estate tax.
    When Annette dies, she still has her $2 million in assets. Using her own
$2 million federal estate tax exemption, she, too, is able to exempt all of
her assets from federal estate tax. Therefore, the Smith children receive
both their father’s $2 million (when the Credit Shelter Trust terminates) and
their mother’s $2 million free from any federal estate taxes. Thanks to the
Credit Shelter Trusts, the Smith children save $800,000 in federal estate
taxes and receive the full $4 million inheritance from their parents.
    Of course, there are additional factors that come into play. Our
discussion presumes that George and Annette neatly divided their assets
and that Annette’s assets do not continue to appreciate over the remainder
of her lifetime. Since it is likely that her assets, if properly invested, will
double every 7 to 10 years, her estate is likely to be far larger than the $2
million tax-free maximum when she dies. Therefore, additional estate
planning may be necessary to offset her potential estate tax liability.
    The $2 million estate tax-free maximum will rise to $3.5 million by 2009,
but will revert back to $1 million in 2011 unless Congress extends the
higher number by that time. There are some curves in the road. As always,
it is best to consult with an elder law attorney to assess the benefits of this
approach in your specific circumstances.