A-B Trust

An A-B trust, also known as a bypass trust or credit shelter trust, is a type of irrevocable trust used for estate planning purposes. The main goal of an A-B trust is to minimize estate taxes by maximizing the use of the federal estate tax exemption. This type of trust comes into play upon the death of the first spouse in a married couple, and it is structured in a way that splits the estate into two separate trusts, Trust A and Trust B.

Purpose and Strategy

The primary purpose of an A-B trust is to take full advantage of the exemption from the federal estate tax that is statutorily allowed to each individual. When a spouse passes away, the estate is divided into two separate trusts:

The assets placed in Trust B are not considered part of the surviving spouse’s estate when they pass away, thereby reducing the taxable estate and potentially saving considerable sums in estate taxes.

Creation and Operation

Establishment of the Trust

An A-B trust is established through the creation of a revocable living trust during the couple’s lifetime. The couple, often acting as co-trustees, can manage and control the assets within the trust while both are alive. Upon the death of the first spouse, the trust is divided into two sub-trusts, A and B.

Funding the Trusts

Upon the first death, the estate assets are allocated to Trust B up to the excludable amount for estate taxes, which leverages the estate tax exemption of the deceased spouse. Any remaining assets are allocated to Trust A, which remains under the control of the surviving spouse.

Trust A operates as a revocable trust, meaning the surviving spouse has the flexibility to alter or revoke it. Trust B, however, becomes irrevocable upon the establishment and is managed according to the terms set out by the deceased spouse, often to benefit the surviving spouse and children.

Management and Distributions

The surviving spouse typically receives income generated from both trusts and may have limited access to the principal of Trust B based on certain criteria, such as health, education, maintenance, or support. This ensures that the surviving spouse is financially supported while preserving the principal of Trust B for eventual distribution to the beneficiaries, usually the children, upon the death of the surviving spouse.

Tax Implications

A-B trusts are particularly valuable in states within the United States that do not allow for portability of the estate tax exemption between spouses. By funding Trust B up to the exemption limit, the estate capitalizes on the maximally available exemption, thus reducing the tax burden on the surviving spouse’s estate. The assets within Trust B will not be subject to estate taxes when the second spouse dies.

Moreover, any appreciation of the assets in Trust B is not included in the surviving spouse’s taxable estate, providing a further tax advantage. This makes A-B trusts highly effective in preserving wealth across generations.

Benefits of A-B Trusts

  1. Tax Efficiency: By utilizing both spouses’ estate tax exemptions, A-B trusts can significantly reduce the estate tax liability for the beneficiaries.
  2. Asset Protection: These trusts protect the deceased spouse’s assets from creditors and potential claims against the surviving spouse.
  3. Control: The deceased spouse can dictate the terms of Trust B, ensuring that the assets are distributed according to their wishes, rather than solely at the discretion of the surviving spouse.
  4. Income Provision: The trust ensures that the surviving spouse retains income and, if needed, limited principal distributions for support and maintenance.

Drawbacks and Considerations

  1. Complexity: Establishing and maintaining A-B trusts require careful planning and administration, often necessitating professional assistance, which may be costly.
  2. Irrevocability of Trust B: Once Trust B is funded, it generally cannot be altered, potentially inflexible in addressing changes in circumstances or laws.
  3. Potential Higher Administrative Costs: Ongoing administrative costs for managing two separate trusts may be higher compared to a simpler estate plan.
  4. Impact on Step-Up in Basis: Assets in Trust B do not receive a step-up in basis at the second spouse’s death, which may lead to higher capital gains taxes for beneficiaries.

Example of A-B Trust in Action

Imagine a couple, John and Jane, with a combined estate worth $10 million. The federal estate tax exemption is $12.92 million (2023). Upon John’s death, his half of the estate, $5 million, is allocated to Trust B. This uses John’s estate tax exemption. Jane’s half remains in Trust A.

When Jane dies, her estate (now potentially appreciated to a greater value if assets appreciated over time) includes only her $5 million plus any growth minus distributions, thereby potentially staying within the exemption limit and avoiding further estate taxes.

Situations for Using A-B Trusts

A-B trusts are particularly suitable for high-net-worth individuals or couples in states without estate tax exemption portability. They are also beneficial for those desiring strict control over the disposition of their assets posthumously and wish to provide for their surviving spouse while minimizing tax liabilities.

Summary

A-B trusts are a sophisticated yet valuable tool in estate planning, particularly for reducing estate tax liabilities and providing controlled financial security for a surviving spouse. Despite some complexities and potential costs, the benefits often outweigh the drawbacks, making them a popular choice among wealthier individuals and families.

To learn more about estate planning and A-B trusts, consider consulting with specialized estate planning services such as Fidelity or Charles Schwab. These institutions can provide detailed, personalized advice and help tailor an estate plan according to your specific needs.