A growing number of Americans with increasing net worths are discovering that their estates may be subject to unexpected taxation once they die. For couples that own highly appreciated assets, avoiding taxes can be a matter of paramount importance to be able to leave as much as possible to their heirs. Couples that don't have millions tied up in their home or finances should also be aware of these estate tax rules because tax laws are subject to frequent changes and these lower net-worth couples could lose the tax shelter they enjoy under the current limit.

In this article, we'll show you how a little careful planning, the use of a credit shelter trust and a step-up in basis can protect your spouse and eventually your heirs from massive estate tax and capital gains tax burdens when you pass on. (For related reading, check out Capital Gains Tax Cuts For Middle Income Investors.)

Estate Planning With Trusts
Most estate plans begin with the creation and use of one or more types of trust. These instruments are legal entities that can buy, hold and sell property and execute the wishes of the grantor after he or she dies. One of the key types of trusts used by estate planners to reduce taxes is known as the credit shelter trust. This trust allows individuals to shelter assets from taxes, bypassing assets that are owned by a husband or wife to the trust instead of directly to their heirs. (To learn more, check out Getting Started On Your Estate Plan.)

Estate tax laws dictate that each person can pass up a certain amount of money to his or her heirs tax-free (see Figure 1 below).

Year Exclusion Amount
2010 Repealed
2011 $1 million
Figure 1: Based on the $4 million-net-worth client couple minimum.

Anything beyond this amount, not passed to a spouse, is subject to estate tax. This may seem like a lot of money, but remember, real estate prices will eat up a lot of this amount and many farmers and ranchers that want to pass down the family farm could be affected. (For a larger discussion of the issues involved, check out Get Ready For The Estate Tax Phase-Out.)

Note: The law places no limits on the value of assets that can be left to an individual's surviving spouse, providing the spouse is a U.S. citizen. For instance, a husband can leave $50 million in asset (value) to his wife without the amount being subject to estate tax, but after 2010 money going to anyone else will be taxed.

A Closer Look at Credit Shelter Trusts
A credit shelter trust allows a married investor to shelter assets from estate tax. Here's how it works: Upon the death of the investor, the assets specified in the trust agreement (up to a specified maximum dollar value) are transferred, estate-tax free, to the beneficiaries named in the trust (normally the couple's children). A key benefit to this type of trust is that the spouse maintains rights to the trust's assets and the income they generate during the remainder of his or her lifetime. There is no estate tax on the assets transferred into the trust and the estate tax exemption mentioned earlier is preserved.

Another important feature of these trusts is that they can provide protection from capital gains tax by providing an automatic step-up in cost basis for any assets with which they are funded. Here's how it works:

Let's say you bought $150,000 worth of stock 20 years ago, and that stock has since appreciated to $2 million. If the stock were liquidated upon your death to be passed down to your heirs there would be capital gains tax applied. However, if the stock is placed within the trust, the cost basis for the stock would be stepped-up to $2 million. The capital gain of $1.85 million will essentially disappear once the stock is placed inside the trust. (For related reading on trusts, read Establishing A Revocable Living Trust

Take Another Step Up
This step-up in basis readjustment can be used more than once if necessary. Couples with substantial holdings of highly appreciated assets can use this technique to significantly reduce their estate tax. The steps necessary to accomplish this are fairly straightforward. They are:

  1. Upon the death of the first spouse, assets - valued up to the exclusion limit - are used to fund the credit shelter trust.
  2. The surviving spouse will then liquidate some of the appreciated assets within the trust and use the proceeds to buy a life insurance policy on him or herself.
  3. When the second spouse passes away, his or her beneficiaries will receive the policy proceeds with a basis of zero. For all practical purposes, the insurance policy provides a second step-up in basis equal to the difference between the value of the assets sold to purchase the policy and the policy's death benefit.
A Closer Look: The second-step-up advantage of credit trust shelters
To illustrate this concept, assume that a wealthy couple, named Milton and Madeline Miser, decides to follow the above strategy with its estate. Milton eventually passes away and $2 million of Milton\'s own company stock, which was bought decades ago for peanuts compared to its current value, passes into the trust. Madeline then sells $750,000 of the stock and uses the proceeds to purchase a $2 million single-premium universal life insurance policy on herself.
When Madeline passes away, the $2 million death benefit will be paid to her beneficiaries. The remaining property inside Milton\'s credit shelter trust will be distributed as well, and both the property and the policy proceeds will have a basis of zero. By purchasing the life insurance policy, Madeline essentially grew the remaining $1.25 million of the trust property into another $2 million with another step-up in basis.
Assuming that the original purchase price of Milton\'s stock was $100,000, the Misers have effectively avoided a taxable capital gain of $1.9 million - plus another $2 million from the insurance policy.


The proper use of this technique in an estate plan can dramatically lower the tax assessed on a decedent's net worth. Of course, issues such as insurability must be considered. At a minimum, couples with highly appreciated assets who can qualify for this strategy would be wise look into it.

Many people miss out on available tax reduction strategies as a result of liquidating assets at the wrong time, or by leaving the assets to the wrong party. To ensure that you receive maximum available tax benefits, you should consider working with an estate planner to design an estate plan and tax reduction strategy that is customized for you and your family.

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