Married couples can maximize the use of both of their federal exemptions from estate tax by using AB Trusts as part of their estate plan. The AB Trust system can be set up under the couples' Last Will and Testaments or Revocable Living Trusts. 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."
AB Trusts and Portability of the Estate Tax Exemption
Note that beginning in 2011, the federal estate tax exemption was made transferable between married couples. This is referred to as "portability of the estate tax exemption" and means that if one spouse dies in 2011 or later and his or her entire federal estate tax exemption is not needed to avoid estate taxes, then the unused portion of the deceased spouse's estate tax exemption can be added to the surviving spouse's estate tax exemption. This, in essence, means that in 2013 a married couple will be able to pass on up to $10,500,000 to their heirs free from federal estate taxes without the need to use AB Trust planning.
So has portability of the estate tax exemption led to the extinction of AB Trusts? Not exactly. If the spouses have different sets of final beneficiaries, such as in the case of a second or later marriage where each spouse has their own children that they want inherit their separate assets after both spouses are deceased, then the couple will want to make use of AB Trust planning in order to insure that their separate beneficiaries will be their ultimate beneficiaries. In addition, since currently none of the states that collect an estate tax have made their state estate tax exemptions portable between married couples, AB Trust or ABC Trust planning may be required in these states in order to take advantage of both spouses' state estate tax exemptions.
How AB Trust Planning Works
Here is how the AB Trust system works to maximize the use of both spouses' estate tax exemptions:
- The couple includes the appropriate AB Trust language in their Last Will and Testaments or Revocable Living Trusts. Note that this should not be attempted without the assistance of a qualified estate planning attorney.
- The couple divides their assets so that each spouse has about the same value of assets in his or her individual name or in the name of his or her Revocable Living Trust. This is an important step and must be done in order for the AB Trust system to work. Many times couples leave their assets in joint accounts and this completely voids the use of the AB Trust system since the joint assets will pass outright to the surviving spouse instead of through the deceased spouse's Last Will or Revocable Living Trust.
- If the first spouse died in 2011, then the first $5,000,000 of his or her assets will be funded into the B Trust; if the first spouse died in 2012, then the first $5,120,000 of his or her assets will be funded into the B Trust; and if the first spouse dies in 2013, then the first $5,250,000 will be funded into the B Trust. This effectively uses the first spouse's $5,000,000, $5,120,000 or $5,250,000 federal exemption from estate taxes that is available for deaths occurring during these respective years. The B Trust can be relatively flexible and used for the benefit of the surviving spouse and descendants or other beneficiaries.
- If the deceased spouse's assets exceed $5,000,000 in 2011, $5,120,000 in 2012 or $5,250,000 in 2013, then the excess is funded into the A Trust. This will defer the payment of estate taxes on the assets above the deceased spouse's exemption until after the surviving spouse's death. Because of 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 the surviving spouse later dies, the surviving spouse will still have his or her own estate tax exemption. If the exemption is $5,250,000 when the surviving spouse dies, then the first $5,250,000 of the surviving spouse's separate assets will pass estate tax free to the final beneficiaries. Anything over $5,250,000 will be taxed.
- 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 estate tax exemption of the first spouse to die, so anything left in the B Trust will pass estate tax free. This can provide a significant 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.
- The assets remaining in the A Trust will be taxed as part of the surviving spouse's estate. As mentioned above, the estate tax on the A Trust is effectively deferred until after the surviving spouse dies.
- The balance of the A Trust that remains after the estate tax bill is paid passes to the final beneficiaries. Note that the beneficiaries of the A and B Trusts can be different.
As illustrated above, effective use of the AB Trust system allows married couples to pass on up to $10,500,000 to their final beneficiaries, free from any federal estate taxes. AB Trust planning also allows married couples to minimize estate taxes while insuring that the their separate estates will ultimately pass to the beneficiaries of their choice and in the manner of their choice.
What Happens if the A Trust is Not Needed? Enter Portability of the Estate Tax Exemption
What happens if the value of the deceased spouse's estate is under the value of the federal estate tax exemption so that there is no need to establish and fund the A Trust? Then the unused portion of the deceased spouse's estate tax exemption can be transferred and added to the surviving spouse's estate tax exemption by timing filing a federal estate tax return, IRS Form 706. This will be important for couples who have lopsided estates (for example, a second or later marriage where one spouse is wealthier than the other) or where the surviving spouse's estate increases significantly in value after the first spouse's death.