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Estate Tax Planning Variations: The Flowcharts

For many of us, the old adage that a picture is worth 1,000 words rings true. This can be especially true with estate plans which are meant to be dynamic. How they work changes over time, so it can be easier to see the flow of funds and changes in the terms of trusts through diagrams.

In a prior post, we showed flowcharts for many of the more standard estate plans clients use. They included a flowchart for estate tax planning that uses so-called QTIP trusts. This is the plan we use with most clients because it provides the most flexibility for surviving spouses. Here’s what it looks like:

Standard Estate Tax Plan (QTIP Trusts)

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The beauty of this plan is its simplicity. It provides for a single trust fund for the surviving spouse which can be sliced and diced to achieve the maximum tax savings available. But it has one significant drawback: the surviving spouse can be the only beneficiary. If you want your children or others to also be beneficiaries of the trust or to be beneficiaries instead of your spouse (for instance in the case of a second marriage), the QTIP plan might not be the best approach for you.

A & B or Credit Shelter Plan

Instead, you may prefer the trust structure that’s often referred to as an “A & B” trust or “credit shelter” plan. Under this plan, the first $1 million, which is the amount that you can give away tax free in Massachusetts, in its own subtrust, often referred to as the “B” or “credit shelter” trust. Under a QTIP plan, the income of this trust would have to be paid to the surviving spouse and distributions of principal could only be paid to them. In contrast, under a “A & B” or “credit shelter” plan both can be paid to other beneficiaries as well or can be accumulated.

Standard Estate Tax Plan (A & B Trusts)

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Under the standard plan, the balance of the trust funds over the $1 million Massachusetts estate tax threshold flow into the “A” or “marital” trust. This is only for the benefit of the surviving spouse and qualifies for the marital deduction that provides that there’s no estate tax on property passing to the surviving spouse no matter the amount.

There’s a lot of flexibility in how this can be drafted. As with QTIP trusts, the surviving spouse must receive the income earned by this subtrust and they can be the only beneficiary of principal distributions, but those principal distributions can be highly restricted or completely unrestricted. Some plans do away with this second subtrust all together, simply having the excess over $1 million distributed outright to the surviving spouse. On the other end of the spectrum, some trusts may not permit any distributions during the surviving spouse’s life, though that is unusual even in the case of second marriages. More common in second-marriage situations is for IRAs to be payable to the A or marital trust with annual minimum distributions going to the surviving spouse.

One potential advantage of accumulating income in the credit shelter trust is that it facilitates the growth of the trust over time, especially if the income is continually reinvested. While only $1 million can be sheltered from estate tax upon the death of the first spouse to die, these funds will never be taxed no matter how large they grow. Here’s how this can work:

Let’s assume a couple has $3 million in total assets. When the first spouse dies, $1 million can be sheltered and will never be subject to estate tax. But the surviving spouse will still have $2 million in their estate, whether in their own name or partially in the marital or QTIP trust left by the deceased spouse. If they were to die immediately, the Massachusetts estate tax would be approximately $100,000. But, instead, let’s assume the surviving spouse lives another 10 years and over that time they spend down their $2 million to $1 million through living expenses and gifts to children and grandchildren. Let’s also suppose that the credit shelter trust grows to $2 million during that time through the accumulation of income and the growth of the underlying expenses. In that case, the estate tax would be completely avoided.

(Of course, nothing is really this simple. One potential disadvantage of accumulating income rather than distributing it to the surviving spouse or other beneficiaries is that the trust may pay a higher tax on the income than beneficiaries would if it were distributed to them. In addition, a potential benefit of paying estate taxes is that the property in the surviving spouse’s taxable estate will receive a step-up in basis at their death, potentially saving even more in taxes on capital gain.)

The Disclaimer Plan

The beauty of the QTIP plan is that it is simple yet provides great flexibility. However, it has its limitations in that the surviving spouse must be the sole beneficiary during their life and income may not be accumulated but must be distributed to the surviving spouse. There’s an alternative that eliminates these limitations, but it’s a bit more complicated.

Estate Tax Disclaimer Plan (Termination on Death of a Survivor)

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Basically, this plan is a combination of the the QTIP and credit shelter plans. The trust is drafted as a standard QTIP plan but with a credit shelter trust added in. In order to fund the credit shelter trust, the surviving spouse must divert funds or property to the credit shelter trust which they do by filing a disclaimer. A disclaimer is an estate administration option that permits anyone inheriting property to turn down the inheritance. The property disclaimed is then distributed as if the person inheriting had died before the decedent.

In the case of a disclaimer trust plan, the surviving spouse can disclaim property that would normally pass to the QTIP trust so that it instead goes to the credit shelter trust. This permits them to make the funds or property available to other beneficiaries based on “the facts on the ground” after the death of the first spouse. This could be the full $1 million or a lesser amount and is more flexible than a standard credit shelter plan which requires that the first $1 million go to the credit shelter subtrust.

A surviving spouse can also disclaim funds coming to them in a standard QTIP trust plan, but in that case they must be distributed outright to the next beneficiaries in line, rather than being protected in a continuing credit shelter trust.

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