Planning for the Wrong Tax: How Credit Shelter Trusts Can Destroy the 2nd Step-Up

Are You Planning for the Wrong Tax? The Step-Up in Basis Trap Hiding Inside “Estate Tax Planning”

Most families who call an estate planning lawyer say the same thing:

“We’re worried about the estate tax.”

Fair. But here’s the twist:

For many Massachusetts families, the tax that actually does the damage isn’t the estate tax at all. It’s capital gains tax—paid later, by your kids, when they sell what you left behind.

And one common planning move can quietly make that capital gains bill worse:

Forcing appreciated assets into a Credit Shelter Trust (also called a Bypass Trust, Exemption Trust, or Family Trust) at the first spouse’s death.

Why? Because assets that are deliberately kept out of the surviving spouse’s taxable estate typically do not receive a second step-up in basis at the surviving spouse’s death.

That second step-up is often where the real money is.

This post breaks it down in plain English:

1. estate tax basics

2. capital gains tax basics

3. step-up in basis basics

4. how credit shelter trusts can cost families avoidable capital gains

5. why a disclaimer-based joint trust can be a smarter “wait-and-see” approach

Estate tax basics: what it is (and who should care)

An estate tax is a tax on what you own (and control) at death—before anything is distributed to heirs.

Massachusetts estate tax

Massachusetts is one of the states that imposes an estate tax. Whether your estate owes tax depends on the size of the estate and the rules in effect at the time of death.

Federal estate tax

The federal estate tax applies to a much smaller slice of families because the federal exemption is much higher (and changes over time). For many families, federal estate tax planning is not the main event.

So yes—estate tax matters. But it’s often not the tax that ends up costing the heirs the most.

Capital gains tax basics: the tax that waits… then hits hard

A capital gain is the profit when an asset sells for more than its cost basis (usually what you paid, plus certain adjustments).

Example:

• You buy stock for $100,000.

• It’s worth $900,000 later.

• If someone sells it, there may be $800,000 of capital gain.

Capital gains tax usually shows up when your heirs sell:

• the family home

• a vacation property

• stocks/mutual funds

• a small business

• investment real estate

And that’s why “estate tax planning” can be the wrong focus. Because the estate tax is a one-time event. Capital gains can be a delayed landmine.

Step-up in basis basics: the rule that can erase decades of gain

Here’s the rule that changes everything:

Most assets included in a decedent’s taxable estate receive a new basis equal to fair market value at death. That’s the “step-up in basis.”

Plain English:

• If Dad bought the house for $150,000

• And it’s worth $1,200,000 when he dies

• The “tax starting point” can reset to about $1,200,000

So if the kids sell soon after death for around $1,200,000, the capital gain can be small—or close to zero.

The trap: Credit Shelter Trusts plan for the wrong tax and sacrifice the second step-up

A Credit Shelter Trust is usually designed to:

• use the first spouse’s estate tax exemption, and

• keep those assets out of the surviving spouse’s taxable estate

That “non-inclusion” feature is the whole point.

But that same feature can create a painful tradeoff:

If the assets are not included in the surviving spouse’s taxable estate, those assets typically do not receive a second step-up in basis at the surviving spouse’s death.

Now think about timeline:

• Spouse #1 dies today.

• Appreciated assets get a step-up today.

• Assets are “locked” in a credit shelter trust for the survivor.

• Spouse #2 dies 5, 10, even 20 years later.

• Those assets may have grown dramatically.

• No second step-up.

• Heirs sell later and pay capital gains tax on years of growth that could have been wiped clean.

That’s the core problem.

Why “two revocable trusts” (and many joint trusts) can push families into planning for the wrong tax

Many couples have:

• His revocable trust

• Her revocable trust
  …and the plan automatically funds a bypass/credit shelter trust at the first death.

That structure is classic estate tax planning.

But if the family isn’t actually facing a meaningful estate tax problem—or if the capital gains downside is bigger—then that automatic funding can be a costly default.

And joint trusts aren’t automatically “safe” either.

If a joint trust automatically creates an irrevocable trust at the first death, you can wind up with the same outcome: estate tax mechanics first, basis planning second.

The better “wait-and-see” approach: a joint trust that uses a disclaimer

Here’s the improvement.

A joint trust that relies on a qualified disclaimer to fund a credit shelter trust is often a better approach because it gives you choice at the first death.

Instead of forcing the plan into a bypass trust no matter what, the survivor (and the family’s advisors) can make the decision with real information in hand.

That “wait-and-see” flexibility matters because at the first death you know things you did not know when the documents were signed:

• What are the actual asset values?

• How much appreciation has already occurred?

• What does the tax law look like now (federal and state)?

• What’s the survivor’s health and life expectancy?

• Is the survivor likely to sell assets soon, or hold for decades?

• Which tax is the bigger threat: estate tax or capital gains?

Two quick examples (the kind that actually happen)

Example 1: survivor is 95 when the first spouse dies
If the survivor is 95, the planning horizon is usually short. In that situation, sheltering assets from estate tax by funding the credit shelter trust can be the better decision more often than not. The opportunity cost of losing a second step-up may be smaller because there may be less time for appreciation.

Example 2: survivor is 60 and healthy when the first spouse dies
If the survivor is 60 and healthy, there may be decades of future appreciation. In that situation, forcing assets into a credit shelter trust can be penny-wise and pound-foolish—because you may be trading away a second step-up that could eliminate a very large capital gains tax bill later.

What the disclaimer approach really buys you

It buys the ability to say:

“We’ll decide later—when we have the facts.”

That’s a smarter posture than locking in an estate-tax-first plan years (or decades) in advance when the bigger risk might turn out to be capital gains.

This isn’t just Massachusetts: state-level “death tax” planning is common

You’re correct: there are 17 jurisdictions with a death tax (including the District of Columbia).

• Estate tax jurisdictions include:
  Connecticut, District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, Washington.

• Inheritance tax states include:
  Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania.

Note: Maryland has both an estate tax and an inheritance tax.

The point isn’t trivia. The point is this:

Wherever state-level death tax planning is common, families are often steered into bypass-trust mechanics—sometimes automatically—without a full basis conversation.

Practical takeaway: don’t fight the wrong war

If your plan is built around an automatic bypass/credit shelter trust funding at the first death, ask one question:

What did we just trade away to get that estate tax result?

Because in many families, what you traded away was the opportunity for a second step-up in basis—and that can be a far bigger tax bill than any estate tax you avoided.

A disclaimer-based joint trust can be a better default because it keeps your options open until the moment the decision actually matters.

Quick FAQ

Do assets in a credit shelter (bypass) trust get a step-up in basis at the surviving spouse’s death?

Often no, because the trust is typically designed to avoid inclusion in the surviving spouse’s estate, which can prevent a second basis adjustment at the survivor’s death.

What is a step-up in basis?

A step-up in basis generally means the asset’s tax basis resets to fair market value at death for qualifying property, which can reduce capital gains tax when heirs sell.

Why can a disclaimer-based joint trust be better?

Because it creates a “wait-and-see” decision point at the first death—letting the family choose whether to fund a credit shelter trust based on the survivor’s age, health, asset values, and the tax laws in effect.

Ready to see which tax is really your biggest threat?

Most families don’t need more “estate tax talk.” They need clarity: Will your family lose more to estate tax—or to capital gains tax because you missed the second step-up in basis?

That’s exactly why the calculators are included at the bottom of this post. Run your numbers, then take the next step:

• Attend our free online webinar to learn the strategies families use to protect wealth and preserve step-up opportunities, or

• Call (508) 775-7800 to schedule a free Estate Planning Strategy Session so we can help you identify the biggest tax risk in your plan and the cleanest way to address it.

When you’re ready, we’ll help you plan for the right tax.

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