The Pros and Cons of Portability Part II - The Continued Importance of a flexible Credit Shelter Trust

Last week I discussed some of the pros and cons of Portability, the federal law recently made permanent, which allows the surviving spouse to carry over the unused portion of the deceased spouse’s estate tax exemption amount. My conclusion was that while Portability is a good back-up plan, for a variety of reasons it should not be the first line of defense against estate taxes.  I continue to believe that the first and best choice in planning to preserve both spouses’ estate tax exemption remains a properly drafted credit shelter trust.While there is an initial up-front cost in drafting a living trust to include the creation of a credit shelter trust following the death of the first spouse, that cost is generally less than the cost of the estate tax return required to take advantage of portability.  The credit shelter trust can be set up so that funding is either mandatory or discretionary.  Because we never really know what the tax situation will be at the time of the first spouse’s passing, my preference is to plan flexibility into the trust and make the funding of the credit shelter trust discretionary.  By using a properly drafted credit shelter trust, if the surviving spouse remarries, the exemption will not be lost.  Additionally, if done properly the surviving spouse will have creditor protection, including protection against claims by the new spouse – I call this re-marriage protection.  These are great benefits that Portability simply cannot provide.An additional consideration exists for those who live or have significant holdings in a state that has its own estate or inheritance tax.  In these states, the amount exempt from the estate tax is often significantly less than the federal exemption.  This means that while you may not have a federal estate tax, you may still owe taxes in your respective state.  In 2013, there are 21 states and the District of Columbia that have some form of separate state estate and/or inheritance tax.  (Click here to see if your state is one).  Portability only applies to the federal estate tax.  However, your credit shelter trust can be drafted to ensure both spouses’ state exemptions are also maximized.While I expect there will be continued evolution with Portability in the coming years, for now, a credit shelter trust is still the best option.