For many people, tax avoidance is a primary estate planning goal. If you are among them, and you are married, you may wish to consider incorporating an AB trust into your estate plan. For those who are unfamiliar with the concept, a Sacramento trust attorney at the Northern California Center for Estate Planning & Elder Law explains the basic fundamentals of an AB trust.
Why Tax Avoidance Is an Important Estate Planning Goal
Historically, an AB trust was used as an estate planning tool to maximize federal and state exemptions to gift and estate taxes. The federal gift and estate tax is effectively a tax on the transfer of wealth that is collected from your estate after you die. The tax applies to all qualifying gifts made during a taxpayer’s lifetime as well as all estate assets owned by the taxpayer at the time of death. Although the federal gift and estate tax rate fluctuated historically, the American Taxpayer Relief Act of 2012 (ATRA) permanently set the rate at 40 percent. In addition, a handful of states also impose a state-level estate tax.
The Lifetime Exemption, the Marital Deduction, and Portability
Every taxpayer is entitled to make use of the lifetime exemption to reduce the amount of federal gift and estate taxes owed by their estate. For a married taxpayer with assets valued above the Lifetime Exemption amount, there was always the unlimited marital deduction. A married taxpayer can use the unlimited marital deduction to leave an unlimited amount of assets to a spouse tax-free. Historically, the problem with using the marital deduction was that it often over-funded the spouse’s estate which effectively only delayed the payment of estate taxes. The solution to that problem was the concept of “portability” which refers to a surviving spouse’s ability to use any unused portion of a deceased spouse’s lifetime exemption.
The Evolution of the AB Trust
With an AB trust, the “A Trust” is also commonly referred to as the “Marital Trust,” “QTIP Trust,” or “Marital Deduction Trust.” The “B Trust” is also commonly referred to as the “Bypass Trust,” “Credit Shelter Trust,” or “Family Trust.” An AB trust system is set up within your Last Will and Testament or in a revocable living trust. The AB trust concept was originally designed to resolve the over-funding problem that the marital deduction often created. With the advent of portability, it may seem as though the need for an AB trust has disappeared; however, that is not always the case. If you have different final beneficiaries than your spouse because this is a second (or subsequent) marriage for you, you may still benefit from an AB trust. In addition, couples who live in states that impose a state level estate tax may still need an AB trust because portability does not always exist in state tax systems.
AB Trust Fundamentals
You and your spouse divide your assets so that you each have approximately the same amount of assets in your name (or in the name of the trust you created). Once the AB trust is established, it works as follows:
If you are the first spouse to die, the current lifetime exemption amount would be funded into the B Trust. This uses your lifetime exemption from federal estate taxes. The B Trust can be relatively flexible and used for the benefit of the surviving spouse and descendants or other beneficiaries. Any excess assets are funded into the A Trust. This will defer the payment of estate taxes on the assets above your lifetime exemption until after the death of your surviving spouse. Due to this estate tax deferment, the A Trust is less flexible and can only be used for the benefit of the surviving spouse. In addition, federal law requires that the surviving spouse must receive all of the income from the A Trust in order for it to qualify for the unlimited marital deduction. When your surviving spouse later dies, he/she will still be entitled to use his or her own lifetime exemption with anything left over being subject to taxation. The assets remaining in the B Trust pass estate tax-free to the final beneficiaries. This is because the B Trust used up the federal exemption of the first spouse to die, so anything left in the B Trust will pass estate tax-free. This is where the benefit of an AB trust comes in by potentially providing a windfall to the final beneficiaries if the surviving spouse does not need to use the assets from the B Trust and they continue to grow in value during the surviving spouse’s remaining lifetime. If there are assets left in the A trust after paying any taxes due, those assets pass to the final beneficiaries which may not be the same beneficiaries as the B trust beneficiaries.
Please download our FREE estate planning checklist. If you have additional questions or concerns about a trust, contact us at the Northern California Center for Estate Planning & Elder Law by calling (916)-437-3500 or by filling out our online contact form.