Achieve a Second Step-up in Cost Basis With a Credit Shelter Trust

For many affluent investors, avoiding income and estate taxes is a major concern. Large estates that are left unprotected can face estate tax bills of up to 50% of their value. Fortunately, there are many things that can be done to reduce or even eliminate estate tax liability that involve establishing trusts and purchasing life insurance.

Married couples who have assets that have substantially appreciated over time can save big dollars on their estate tax bills by establishing a credit shelter trust. What is a credit shelter trust? This type of trust allows each spouse to take advantage of their unified credit amount ($5,120,000 through 2012) by transferring their share of assets (up to the limit) into the trust when they die. These appreciated assets will receive a 'step-up' in basis upon the death of the first spouse, which means that none of the appreciation of the assets up to the time that they are placed in the trust will be taxed. Then, the surviving spouse will immediately (before the assets appreciate any further) sell a portion of the assets in the trust and use the proceeds to buy a life insurance policy on him or herself with the trust as the beneficiary. Therefore, when the surviving spouse passes away, the trust will receive the entire death benefit, with no tax liability. For all practical purposes, the assets of the trust that were received from the first spouse to die grew to the amount of the life insurance death benefit of the surviving spouse upon his or her death.

As an example, consider Joe and Betty Smith, a hypothetical wealthy couple with about $12 million in assets. Joe is the majority shareholder in his family business, and will most likely be outlived by his wife. Joe and Betty set up a credit shelter trust. Joe eventually dies and transfers $5 million of his company stock into the trust. Betty uses $650,000 of it to purchase a $2 million single-premium life insurance policy on herself. When she dies, the death benefit will join Joe's stock in the trust and pass to their heirs tax-free. In this case, the heirs receive $10 million free of estate tax (plus additional assets owned by Betty that will be subject to estate tax).