What is an A-B Trust?
An A-B Trust is a trust created by a married couple with the aim of minimizing estate taxes. It is formed by both spouses placing assets into the trust and designating any suitable individuals other than the remaining spouse as the ultimate beneficiaries. This trust is named because, upon the death of one spouse, the couple's assets are split into two separate entities: Trust A (the survivor's trust) and Trust B (the deceased's trust or bypass trust).
Key Points:
- An A-B Trust is a joint trust created by a married couple that splits into two parts—Trust A (the survivor's trust) and Trust B (the deceased's trust or bypass trust) upon the death of one spouse.
- By dividing the assets into two separate entities, the A-B Trust effectively minimizes estate taxes, deferring them until the surviving spouse's death.
- The surviving spouse has limited control over Trust B, but the terms of Trust B may allow the surviving spouse to access assets or receive income from it.
- Due to the significant increase in estate tax exemption limits, the use of A-B Trusts has become less common, as the exemptions are sufficient for most estates.
Understanding A-B Trusts
Estate taxes can significantly erode a deceased person's assets. For example, in the U.S., if a married couple has $20 million in assets and one spouse dies, the surviving spouse inherits all $20 million tax-free due to exemptions for spousal transfers.
However, if the surviving spouse then passes away and leaves the estate to their children, the taxable portion of the estate would be $7.08 million (exceeding the 2023 exemption threshold of $12.92 million), resulting in a 40% tax on $7.08 million ($4.25 million in taxes), leaving the children with $17.17 million ($12.92 million + $4.25 million).
To avoid such high estate taxes, many couples establish an A-B Trust in their will. In the earlier example, with an A-B Trust, the death of the first spouse wouldn't trigger estate taxes due to the exemption. An amount equal to the estate tax exemption would be transferred to an irrevocable trust, known as the B trust or bypass trust.
This trust, also called a deceased's trust, would hold the excess $7.08 million in assets, with the surviving spouse fully controlling the A trust. Estate taxes on the A trust are deferred until the surviving spouse's death.
If the surviving spouse elects portability upon the first spouse's death, then the deceased spouse's exemption (i.e., $12.92 million in the example) transfers to the surviving spouse, effectively shielding the entire $20 million estate from taxes with a combined exemption of $25.84 million, reducing the need for an A-B Trust.
Advantages of A-B Trusts
Although the A trust includes assets benefiting the surviving spouse, the control over assets in the B trust (the deceased spouse's trust) is limited. Nonetheless, the terms of the B trust may allow the surviving spouse to use some of the assets (like real estate) and receive income generated from the B trust.
The surviving spouse can use the A-B Trust when necessary, but the assets within the trust bypass taxable estates after both spouses pass away. Only assets within the A trust are subject to estate taxes upon the surviving spouse's death. If the surviving spouse's estate tax exemption is also $12.92 million in 2023 and the deceased's trust assets are $7.08 million, no estate taxes would be due.
The federal tax exemption can be transferred between married couples through "portability." If one spouse dies, their unused portion of the exemption can be transferred to the surviving spouse's exemption. Upon the surviving spouse's death, the assets in the deceased's trust are tax-free to the beneficiaries named in the trust.
This is because the B trust utilizes the deceased spouse's estate tax exemption, so all remaining assets are transferred tax-free. The deceased's trust avoids double taxation by not being part of the surviving spouse's estate for tax purposes.
Net Worth and A-B Trusts
If the deceased spouse's estate does not exceed their estate tax exemption, establishing a survivor's trust may not be necessary. The unused exemption portion can be transferred to the surviving spouse's exemption through registration and application processes with the relevant authorities.
Why Are A-B Trusts Becoming Obsolete?
While not entirely obsolete, A-B Trusts are less common due to changes in estate tax laws that offer high exemption limits for married couples. A-B Trusts were primarily designed to reduce estate taxes between spouses.
Though effective in reducing estate taxes, A-B Trusts are seldom used today. In the early 21st century, they were popular because estate tax exemptions hadn't been adjusted for years, and even estates as small as $1-2 million were taxed. As of 2023, the lifetime federal gift and estate tax exemption is $12.92 million per individual ($25.84 million for married couples).
Therefore, in 2023, only estates worth more than $12.92 million for individuals or $25.84 million for couples would consider an A-B Trust. Under portability, the surviving spouse can absorb the deceased spouse's exemption ($25.84 million in 2023). Additionally, applying within nine months allows the deceased spouse's exemption to be transferred to the beneficiaries.
Conclusion
While A-B Trusts can be beneficial for estate planning to reduce taxes, their usage frequency has decreased due to higher exemption limits in recent years. When preparing to pass your assets to heirs, consulting a tax advisor to find the best tax-reduction strategies is advisable.
