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How to Modify a Credit Shelter Trust without Destroying Tax Benefits

Published: September 4th, 2014

By: Brian M. Malec

How to Modify a Credit Shelter Trust without Destroying Tax Benefits

A credit shelter trust, often referred to as the “Family Trust,” helps married couples avoid estate taxes when passing assets to their heirs. Upon the death of the settlor, the spouse benefits from the trust assets and the income they generate for the remainder of his or her lifetime. When the surviving spouse dies, the assets in the credit shelter trust are transferred to the beneficiaries (usually children) without any estate taxes levied against those assets. The result can be a significant tax savings.

The beneficiaries of the credit shelter trust may have different goals and needs, which can lead to conflict. One solution may be to modify the credit shelter trust, but can you do that without destroying the tax benefits? The answer is “yes, in some cases.”

To help illustrate this possibility, we’ve created a scenario based on the popular 1990s sitcom, “The Fresh Prince of Bel-Air.”

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This is a Story About the Banks Family…

Let’s assume “Uncle Phil” Banks dies, survived by his wife, Vivian, his son, Carlton, and his (adopted) son, Will. Phil leaves a credit shelter trust that provides for discretionary distributions to Vivian for health, education, maintenance and support (HEMS) during her lifetime. Upon her death, the trust will split into dynasty trusts for Carlton and Will.

The credit shelter trust owns $1 million in securities, $2 million in rental properties, and a 100 percent interest in a family dance studio business (that Carlton now manages) valued at $2 million. Carlton, being a gifted businessman and dancer, expects to double the value of the dance studio over the next five years now that he is in control and can teach his “signature” moves.

However, Carlton hates the idea that his efforts to enhance the business could benefit Will and Will’s descendants in the future.

Will thinks Carlton is a disaster, and, thus, he wants nothing whatsoever to do with the business. Upon Vivian’s death, there is sure to be a fight between Will and Carlton regarding the division of the trust assets, primarily due to the growth or decline of the value of the business. During Vivian’s lifetime, though, Will and Carlton certainly will cooperate because they want an inheritance from Vivian.

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What Can Save the Banks Family?

The solution is simple: Sever and modify the credit shelter trust into two trusts.

  • Trust No. 1 will be for the benefit of Vivian for life, with a remainder to Will in trust. Trust No. 1 will own the rental properties ($2 million) and $500,000 in securities.
  • Trust No. 2 will be for the benefit of Vivian for life, with a remainder to Carlton in trust. Trust No. 2 will own the interest in the family business ($2 million) and $500,000 in securities.

The remaining terms of the trusts will be identical to the original credit shelter trust.

Benefits of Severance and Modification

The benefits of severance and modification are:

  1. Each trust has assets worth $2.5 million.
  2. Only Vivian, Carlton and his descendants will share in the success or failure of the business. The share for Will and his descendants is not affected by the performance of the business.
  3. Each trust has assets that, with Vivian’s consent, can be independently invested without the consent of the other child.
  4. Vivian, Will and Carlton may agree that distributions for Vivian will be made equally from Trust No. 1 and Trust No. 2.

Income Tax Issues

One concern is that the exchange of interests by Will and Carlton could be treated as a sale or exchange under IRC Section 1001, which could result in a gain or loss to Will and Carlton to the extent the amount realized exceeds basis. This concern arises because the trusts will have separate assets and not one-half of each asset of the credit shelter trust. This is considered to be a non-pro rata division of the assets.

Treasury Regulation Section 1.1001-1(h) states that the severance of a trust is not an exchange of property for other property differing materially in either kind or extent if:

  1. The severance is permitted by the trust or state statute, and
  2. Any non-pro rata funding is authorized by the trust or state statute.

If non-pro rata funding is prohibited, but is used anyway, such a transaction will be treated as pro rata funding followed by an exchange of assets between the trusts. The exchange of assets is a taxable transaction.

The landmark case to consider is Cottage Savings Associations v. Commissioner, 499 U.S. 554 (1991), which indicates the exchange of interests results in a disposition under IRC Section 1001 only if the interests exchanged are “materially different in kind or extent.” This requires a comparison of legal entitlements before and after the modification. This test has been applied by the IRS in numerous cases when analyzing whether a trust modification will be a taxable disposition by the beneficiaries for income tax purposes.

Other issues in this scenario could arise regarding gift taxes and generation-skipping transfer (GST) taxes.

The takeaway here is to consider probable issues before they arise and find a practical solution. It’s much easier to thoughtfully avoid a problem before it arises than to fix a problem after the damage is already done.

The scenario described above is taken from the recent seminar that was presented by Dean Mead’s Estate & Succession Planning department on August 5, 2014 in Orlando.  Please check back in a week and we’ll provide another case study that was included in that presentation.