Marital and Credit Shelter Trust Funding Formulas, Part 1

Intro to A/B formulas and related income tax issues

This is a continuation of the series on everything you ever wanted to know about estate planning trusts.  For an intro and index to this series, please click here.  The linked article will have a series index that gets updated periodically as well, so please bookmark it.

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Table of Contents

1. Background and Recap

2. A/B Formulas – Pecuniary Amounts

3. Fractional Funding, and Pre-Residuary Adjustments

4. Special Cases

   1. Prior Portability

   2. Non-Citizen Spouse

   3. IRC Section 1022 Language

5. Conclusion, and Executive Summary

Background and Recap

In prior articles, we discussed credit shelter trusts and marital trusts.  These are common elements of an estate plan, which play dual roles in an estate plan for a married couple: (1) partial or full protection from claims of creditors against a spouse and/or descendants, and (2) maximization of the available estate tax applicable credit, coupled with deferral of estate tax until the survivor’s death if the applicable credit is used up. 

These trusts may be created as irrevocable testamentary trusts under a will, or as irrevocable subtrusts under a revocable trust (that itself becomes irrevocable at a settlor’s death).  These authorizing instruments usually include the terms for administering the credit shelter trust and/or marital trust, if one is created.  However, there is one key difference that is important when examining an estate plan – the funding formula.  (Note also that some estate plans with SLATs may instead provide for a pourover of the amount earmarked for a credit shelter trust to a SLAT created during life by the decedent.)

There are many formulas – some of which have become more popular after the creation of the portability election – but this article focuses primarily on what is commonly known as an A/B formula.  This formula has, as its primary goal, the preservation of the deceased spouse’s unused applicable exclusion through transfers of assets in the residuary to a credit shelter trust.  These transfers use this applicable credit (after reduction for specific gifts and nonprobate transfers), with the trade-off being no estate tax at the surviving spouse’s death.  If the taxable estate is greater than this unused exclusion, then the balance will usually pass to a spouse in a transfer that qualifies for the estate tax marital deduction – often into a marital trust. 

We won’t get into the deeper numbers and assets behind the actual “words” of the funding formula in this article, as the numbers come with more permutations than are apparent at first glance.  The permutations can also affect which assets pass into each trust, whether trusts are funded with fractional shares of assets or with entire assets in-kind, and whether post-death appreciation is recognized as gain to the estate or revocable trust. 

In this vein, however, note that these trusts are usually funded with assets that got a step-up or step-down in basis to the date-of-death value as of the decedent’s death.  (Note that the alternate valuation date under IRC Section 2032 usually won’t apply, as it requires a reduction in estate tax and the formula itself should zero out estate tax at first death.)  Any post-death gain or loss recognized on distribution can also increase or decrease the basis of assets going into these trusts under Treas. Reg. 1.661-2(f) using what we will come to know as a pecuniary funding formula.  But, a fractional funding formula means that no post-death appreciation or depreciation is recognized on funding.  Basis at the surviving spouse’s death will only be stepped up or down for the marital trust, and not for the credit shelter trust (since there is no gross estate inclusion of the credit shelter trust at second death). 

Further adjustments into GST-exempt and -nonexempt shares can occur.  However, in this vein, you will usually have either exempt and nonexempt shares of the credit shelter trust, or marital trust, but not both.  These formulas will be discussed in a separate article, and also as part of the redux of the video series on the basics of GST tax. 

And, as we will circle back to towards the end, these formulas and the drafting thereof may change post-sunset.  We will explore possible language tweaks to consider in light of this possibility.