November 29, 2010

A/B Trust

If you have a rather large estate, then you might have heard of a legal document known as an A/B trust. Here are some common questions associated with an A/B trust.

1. What is an A/B trust?

An A/B trust is an estate planning device used by couples in which the surviving spouse utilizes the applicable estate tax exemption of the deceased spouse through the medium of a separate trust. It sounds complicated but in application it is straight-forward. If the estate tax is not amended for 2011, then the applicable exclusion amount will be $1 million. Consequently, if your estate then exceeds $1 million, then that portion will be subject to the estate tax. However, tax law favorably treats transfers among spouses and thereby an A/B trust comes into play. IRC §2056.

In regards to the estate tax, tax law allows the surviving spouse to utilize the deceased spouse' applicable exclusion amount when they pass away. 

For instance, Hal and Wendy were a married couple whose estate was worth $2 million. They also had two kids named Samuel and Donna. Hal unfortunately passed away in June 2011 in an auto accident (call me clairvoyant). Wendy is potentially faced with an enormous tax bill in that $1 million will be subject to the estate tax. Yet Hal and Wendy carefully planned for a day like this when they drafted their estate plan years earlier. 

Hal and Wendy's joint marital trust allowed for two additional trusts to be created when the first spouse passed away, an A trust, also known as a Survivor's trust and a B trust, also known as a Bypass or Credit Shelter trust. The B trust would be funded with Hal's applicable exclusion amount, namely $1 million. Conversely, the A trust would be funded with the remainder of the estate not allocated to the B trust. In this case, that would be $1 million. Thereby, Wendy would not have to pay the estate tax on Hal's passing even though his estate exceed the exclusion amount, $1 million.

Years later, Wendy passes on and leaves everything to her two children Samuel and Donna. At her death, Wendy's A trust is worth $800,00 and the B trust is worth $900,000. Had a B trust not been created, Samuel and Donna would have to pay the estate tax because Wendy's estate exceeds the applicable exclusion amount, $1 million. In particular, Wendy's estate would be subject to roughly a 43% tax on $700,000, the amount over the $1 million estate tax exemption. However, since Hal and Wendy created an A/B trust, their children are spared from paying the estate tax. The reason for this is because the B trust is not included in Wendy's estate for estate tax purposes.

This example assumes that the estate tax is not amended from the $1 million exemption amount that comes into effect in 2011.  

2. Are there any important prerequisites for creating an A/B trust?

Yes, since federal law does not recognize same-sex partnerships, only heterosexual couples may take advantage of an A/B trust.1 USC §7. Furthermore, only U.S. citizens may create an A/B trust. IRC §2056(d)(4).

3. Do I need an A/B trust?

The answer to this question is not a simple yes or no response. An A/B trust only comes into play when married couples have an estate larger than the applicable estate tax exemption amount. For instance, if Hal and Wendy 's estate from example 1 was $200,000, then it would not make sense to create an A/B trust since the estate tax would not be an issue for them.  However, it is reasonable to assert that the net worth of couples can change dramatically over time, whether through employment or good fortune. Hence, it would be imprudent to say that an A/B trust is never appropriate. Ultimately, each couple's situation needs to be evaluated on a case by case basis.

4. What are the benefits of an A/B trust?

The main reason why an A/B trust is drafted is to lessen the effects of the estate tax. An A/B trust essentially allows a married couple to leave twice the applicable estate tax exemption amount to their beneficiaries free of tax. For example, if the estate tax exemption is increased to $3.5 million, this basically allows parents to leave to their children $7 million tax free.

5. What are some of the costs of an A/B trust?

Since there are multiple trusts involved, there is a large amount of administrative work involved. This takes the form of filing tax returns, segregating the trusts assets, following the terms of the two trusts, distributing the assets in accordance with the terms of the trust, etc.