What is a Credit Shelter or A/B Trust and how does it work?

A Credit Shelter Trust, also referred to as a Bypass or A/B Trust is utilized to reduce or eliminate federal estate taxes and is commonly employed by a married couple with a sizable estate surpassing the federal estate tax exemption amount. For instance, in 2023, each individual is entitled to an exemption of estate tax on the initial $12.92 million of their assets.
Due to the Unlimited Marital Deduction, a married individual can leave an unlimited number of assets to their spouse, exempt from federal estate taxes and without exhausting their estate tax exemption. However, for individuals with substantial assets, the Unlimited Marital Deduction does not eradicate estate taxes but only postpones them. This occurs when the second spouse passes away with an estate worth more than the exemption amount, subjecting their estate to taxes on the surplus. Meanwhile, the first spouse’s estate tax credit remains unused and effectively wasted. The purpose of a Credit Shelter Trust is to prevent this scenario. Upon the demise of the first spouse, the Credit Shelter Trust establishes a separate, irrevocable trust with the deceased spouse’s portion of the trust’s assets. The surviving spouse becomes the beneficiary of this trust, with the children as beneficiaries of the remaining interest. The irrevocable trust is funded up to the extent of the first spouse’s exemption. Consequently, the amount held in the irrevocable trust is not liable to estate taxes upon the first spouse’s death, allowing the trust to fully utilize the first spouse’s estate tax credit. The trust contains specific provisions to provide limited control of the trust assets to the surviving spouse, ensuring that the assets in the trust remain exempt from federal estate taxation, even if the trust’s value surpasses the exemption amount by the time the surviving spouse passes away.

A Credit Shelter Trust, also referred to as a Bypass or A/B Trust is utilized to decrease or eliminate federal estate taxes and is commonly used by a married couple whose estate exceeds the amount exempt from federal estate tax.
Due to the Unlimited Marital Deduction, a married person is allowed to leave an unlimited amount of assets to his or her spouse, exempt from federal estate taxes, without depleting any of his or her estate tax exemption. However, for individuals with considerable assets, the Unlimited Marital Deduction does not eradicate estate taxes, but merely serves to defer them. This is because when the second spouse passes away with an estate valued beyond the exemption amount, his or her estate might be subject to estate tax on the amount surpassing the exemption. Meanwhile, the estate tax credit of the first spouse remains unused and essentially wasted. This can be avoided by ensuring that an estate tax return is filed after the death of the first spouse, even if no taxes are owed. The purpose of a Credit Shelter Trust is to ensure the preservation of both spouses’ exemptions. Following the death of the first spouse, the Credit Shelter Trust establishes a separate, unchangeable trust containing the deceased spouse’s portion of the trust’s assets. The surviving spouse becomes the beneficiary of this trust, with the children as beneficiaries of the remaining interest. This unchangeable trust is funded up to the extent of the first spouse’s exemption. Consequently, the amount in the unchangeable trust is not subject to estate taxes upon the death of the first spouse, and the trust fully maximizes the first spouse’s estate tax credit. Specific language in the trust grants limited control of the trust assets to the surviving spouse, preventing the assets in that trust from becoming liable to federal estate taxation, even if the value of the trust eventually surpasses the exemption amount by the time the surviving spouse passes away.