State death tax credit in credit-shelter trust funding.

Most estate plans provide that, on the closing of a decedent's estate, the assets are divided between a credit shelter amount and a marital deduction share. The credit-shelter trust is typically funded based on a formula defining the amount necessary after deductions to produce a tax equal to "all available credits." In this way, the tax on the funding of the nonmarital share is completely offset by credits, with no Federal tax due on the first spouse's death.

If the phrase "all available credits" is defined as only the Federal unified credit (Sec. 2011), the credit-shelter trust would typically be funded with $650,000 for the estate of a decedent who died in 1999 and had not used any of his applicable exclusion amount during life. If, however, the phrase "all available credits" includes the state death tax credit (Sec. 2012), the credit-shelter trust can be funded with $698,484.84. This taxable estate is determined based on the calculations and tax rate tables in Exhibit 1.

Exhibit 1: Taxable Estate Calculations

                          Federal estate tax   State tax credit

Taxable estate                $698,484.85         $698,484.85
Less: Exemption                       n/a         (60,000.00)
Adjusted taxable estate        698,484.85          638,484.85
Less: Base amount            (500,000.00)        (440,000.00)
                               198,484.85          198,484.85
Rate bracket                        x 37%               x 04%
Excess tax                      73,439.39            7,939.39
Base tax                       155,800.00           10,000.00
Tentative tax                  229,239.39           17,939.39
Unified credit               (211,300.00)                 N/A
  Net tax/credit               $17,939.39          $17,939.39

Thus, if the credit-shelter trust is $698,484.85, the Federal tax of $17,939.39 will be completely offset by the maximum state death tax credit; no Federal tax would be owed. Obviously, if the only variable were the Federal estate taxes, it would be preferable to fund the credit-shelter trust with $698,485, rather than just $650,000, as the additional amounts in the trust (and all future appreciation thereon) will escape Federal taxes at the time of the surviving spouse's death.

"Pick-Up Tax" States

Many states assess death taxes in an amount equal only to the maximum state death tax claimed on the Federal estate tax return. These states are commonly referred to as "pick-up tax" states, as the only tax assessed is the amount claimed as a credit at the Federal level. In these states, if the credit-shelter trust is funded with no more than $650,000, there would be no state death tax credit claimed at the Federal level and no tax owed to the state. If, however, the credit-shelter trust is funded with $698,484.85, although there is still no Federal estate tax owed, there would be $17,939 of tax owed to the state.

From a purely mathematical viewpoint, this "overfunding" of the credit-shelter trust is probably still beneficial, in spite of the amount owed to the state; $48,484 would be removed from the surviving spouse's taxable estate. Assuming that the surviving spouse will have a taxable estate, removing these funds will reduce the subsequent tax (at tax rates of 37% to 60%) by an amount greater than the state tax owed. In addition, all future growth on this additional $48,484 is removed from the subsequent spouse's estate, thus increasing the tax savings resulting from this plan.

Inheritance Tax States

For states that impose not only a state "estate tax" (i.e., "pick-up tax") but also an inheritance tax, there will typically be some inheritance tax owed, even if the credit-shelter trust is only funded at $650,000. In Indiana, for example, the inheritance tax is calculated on the amount (or portion) of the income interest and remainder interest in the trust attributable to someone other than the surviving spouse. In these states, it may actually make more sense to fund the credit-shelter trust with an amount (between $650,000 and $698,484) that would produce a tax equal to the unified credit plus an amount of state death tax credit (at the Federal level) approximately equal to the inheritance tax that would be owed.

Example: A will creates a credit-shelter trust for $650,000, the income of which will be distributed to the surviving spouse (age 85) for her life, with the remainder passing to their only son at her death. The Indiana inheritance tax on the husband's estate would be $7,645. If the same trust were instead funded with $670,663, the Federal estate tax would be exactly $7,645, which would be offset by the Federal credit for state death taxes. Whether the trust is funded with $650,000 or $670,663, there is no Federal estate tax owed, due to the unified credit and the state death tax credit. Because of the extra $20,663 funding, however, the Indiana inheritance tax would grow from $7,645 to $7,864. This additional $219 "cost" in Indiana inheritance tax is more than offset by the benefit derived by the additional funding to the credit-shelter trust. Thus, it is advantageous to "overfund" the credit-shelter trust with additional funds to produce a Federal death tax credit equal to the inheritance tax that would be owed.

A problem with attempting to fund the credit-shelter trust for more than $650,000 is that the funding provisions for most credit-shelter trusts include a clause indicating that the phrase "all available credits" is to include "state death tax credits (but only to the extent that such funding does not create any additional state death taxes)." As shown, the increase in the credit-shelter trust from $650,000 to $670,663 produces additional inheritance tax of just over $200 and, thus, the parenthetical language would require that the trust be funded with only $650,000.

Therefore, it would be advantageous to change the language in the parentheses to instead refer solely to the pick-up tax. In Indiana, for example, the pick-up tax is called the Indiana estate tax and, thus, the document could instead read, "including state death tax credits (but only to the extent that the funding does not create any additional state estate taxes)" In this way, the trustee would, in effect, be instructed to fund the credit-shelter trust with an amount that could produce a small marginal increase in the state inheritance tax, but would fully use the state death tax credit for the inheritance tax that would be owed.

FROM MARVIN D. HILLS, CPA, SOUTH BEND, IN3