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Friday, June 26, 2015

Minimize Illinois Estate Tax with a Credit Shelter Trust

Photo courtesy of Terry Johnston
Imagine Joe and Mary are a retired Naperville couple with a combined $7.5 million in Illinois assets.  Joe has $5 million in his name, and Mary has $2.5 million in her name.  Both are 85 years old and trying to maximize the amount of money that passes to their children after their deaths.

Let’s discuss how one type of estate planning tool, the credit shelter trust, can make over a $600,000 difference in their Illinois estate tax bill.  We will do this by considering two hypothetical scenarios.  First, we will consider a scenario where Joe and Mary simply have a will giving all their possessions to their spouse upon death, and if neither spouse is alive, to the children.  The second scenario is one where they set up a credit shelter trust.


THE FIRST SCENARIO – PAY TAXES!


Joe dies in July of 2015.  At his death, per the terms of his will, his entire $5 million passes to Mary.  Illinois has an estate tax threshold of $4 million, meaning that Joe would ordinarily owe taxes if he passed on more than $4 million at death.  However, transfers from one spouse to another are exempt from tax, no matter their size.  Therefore, there will be no taxes resulting from Joe’s death and Mary’s inheritance of $5 million.  But the family is not in the clear.

After receiving her inheritance, Mary now has $7.5 million in her own name (the $2.5 million she originally owned plus $5 million after Joe’s death).

Mary dies in November of 2015.  Her estate is well over the $4 million Illinois estate tax threshold.  And worse, she will not only owe taxes on all money over $4 million.  Illinois back-taxes the first $4 million as well.  Based on prior-year tax rates, the family can expect to pay over $622,000 in estate tax after Mary’s death.

Review the second scenario to see how this could have been avoided entirely:

THE SECOND SCENARIO:  PAY NO TAXES


Joe and Mary talk to their estate planning attorney about ways to plan around the Illinois Estate Tax.  They decide on two methods:  Equalization and a credit shelter trust. 

Equalization is simple:  During their lives, Joe gives Mary $1.25 million to put into one of her accounts.  Now they each have $3.75 million in their individual names.  

The next step is to prepare the credit shelter trusts.  There are many different ways to structure a credit shelter trust, but we will use a simple version for purposes of this hypothetical.

The estate plan says that at Joe’s death, Joe will put as much money as possible, up to the full amount of the Illinois Estate Tax exemption amount (currently $4 million), into a credit shelter trust.  A credit shelter trust is a legal device where the trust money is held by somebody (a trustee) for the benefit of whoever Joe names in his estate planning documents.  The key is that funds do not go to Mary, and therefore do not increase her wealth.

If Joe were to die with more than $4 million (which is over the Illinois estate tax exemption amount), the credit shelter trust would only be funded up to the estate tax exemption amount, and any remaining funds would pass to his wife.  This ensures that no matter what, taxes would not be owed at Joe's death.  His wife’s plan has the exact same language, just in reverse.

At Joe’s death, he has $3.75 million of assets, which is below the Illinois exemption amount, so the full $3.75 million can go into the credit shelter trust.  The transfer is below the Illinois threshold of $4 million, so it passes tax free.  Crucially, because the money does not transfer directly to Mary, Mary’s assets do not grow in size.

However, Mary still benefits from the credit shelter trust during her life.  The trustee of the credit shelter trust (perhaps a friend or family member) makes regular payments for the health, education, maintenance, and support of Mary while she is alive, using the trust funds.  In the government’s eyes, if managed properly, the money in the trust does not belong to Mary, even though she may benefit from it.  The key is that someone else has discretion to make payments to her, and/or that there is an ascertainable standard in the trust document (health, education, maintenance, and support) for making payments.  After Mary’s death, the trust money passes to whoever Joe appointed in the trust document (let’s say Joe and Mary’s children).

Because Mary does not own the credit shelter trust funds, the only assets in her estate at her death in November are her $3.75 million.  $3.75 million is below the $4 million Illinois estate tax exemption amount, so she owes no tax.

The family saves over $622,000 in estate tax!

A FEW NOTES


This article deals with the Illinois estate tax.  Federal estate tax is calculated separately, and requires a separate analysis.

Note that this article also deals only with estate tax.  Income tax is a separate type of tax, also requiring planning.  The family in this article may also benefit significantly from an income tax benefit known as the automatic step-up in basis at death, which is discussed here.

The analysis above dealt with an opposite-sex married couple, but it would also apply to a same-sex married couple, both under state and federal law.

CONCLUSION


There are many different forms of credit shelter trusts, and this is a simple example.  But it shows how a little bit of planning can save a family over a half million dollars in state taxes. 

Many estate planning articles are devoted to federal estate tax, but few focus on state issues.  However, as can be seen from the analysis above, even state taxes can have a big impact on a family’s tax bill.

Published by Ian Holzhauer, Esq. of Nagle Obarski PC in Naperville, IL.  

Note:  The information above is not legal advice and is not the basis of an attorney-client relationship.  If you need assistance, you can hire an attorney to assist you with your individual legal needs.  

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