AB Living Trusts and AB Disclaimer Trusts
The AB living trust (aka bypass trust, family trust, credit shelter trust) has a number of benefits for a married couple that allows both spouses to use the full amount of their federal estate tax exemption, while allowing the first-to-die spouse to provide support for his spouse while maintaining control over the ultimate disposition of his property. The federal estate tax exemption is the amount that is not subject to federal estate tax, which, as of 2016, is more than $5,430,000, and adjusted annually for inflation.
Important Note! The American Taxpayer Relief Act of 2012 has added an exemption portability, which allows the decedent to leave any unused estate or gift tax exemption (referred to as the deceased spousal unused exclusion, or DSUE) to a surviving spouse, thereby eliminating the primary purpose for an AB living trust or AB disclaimer trust. The executor of the decedent spouse must make the election on Part 6 — Portability of the Deceased Spousal Unused Exclusion of Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. However, the surviving spouse can only use the DSUE of her last deceased spouse. The AB trust still has certain advantages over choosing the portability option, in that the AB trust will still be able to use the exemption of the deceased spouse even if the spouse remarries, the trust assets will go to the decedent's chosen beneficiaries, and the assets in the trust can appreciate in value without adding to the estate value of the surviving spouse. Additionally, a bypass trust can be used to preserve the generation-skipping transfer tax exemption of the decedent spouse by applying it to the trust property, since the portability option does not apply to the GSTT exemption.
Consider the possibilities of the couple with property worth more than the estate tax exemption but less than twice the tax exemption. Without the use of a trust, the deceased spouse can leave all of his property to either:
- the surviving spouse and take advantage of the unlimited marital deduction; however, his GSTT exemption is lost, so that when the surviving spouse dies, only her GSTT exemption can be applied to the property, and if the property appreciates, then the appreciation will be includable in the surviving spouse's estate;
- or to his ultimate beneficiaries, but then no support is provided to the surviving spouse.
Example – Federal Estate Taxes without a Trust
Consider a couple where each spouse has $5 million worth of property and the federal estate tax exemption is $5 million. The couple intends to leave all of their property to their children and the husband is the 1st to die.
Scenario 1: The husband leaves all of his property to his wife. No estate tax is due because of the unlimited marital deduction. However, when the wife dies, her estate will be worth $10 million, but only her tax exemption of $5 million can be applied to the property. Therefore, estate tax will be due on the $5 million above the wife's tax exemption, leaving less for their children. Net result: Support is provided for the wife during her lifetime, but her estate must pay estate tax on the $5 million received from her husband.
Scenario 2: The husband leaves all of his property to their children. No estate tax is due because the children benefit from their father's tax exemption. However, no support is provided to the surviving spouse. But when the surviving spouse dies, then the children can inherit the $5 million of their mother's estate also free of estate tax. Net result: The children inherit $10,000,000 free of estate tax, but no support was provided to the surviving spouse.
Scenario 3: The wife uses the portability option of the deceased husband instead of using the AB trust. By the time the wife dies, the deceased husband's assets increase in value to $8 million and the wife's exemption amount has also increased to $6 million at the time of her death, since the exemption is adjusted annually for inflation. Therefore, even if the assets of the wife did not increase in value, the total estate value will be $14 million. However, only $5 million of the assets protected under the portability exemption plus the $6 million exemption of the wife will only shield $11 million of the estate from taxes. The remaining $3 million will be subject to a 40% tax of $1,200,000. If the wife had remarried, then the $5 million exemption of the deceased husband would be lost. Furthermore, the wife can decide to give those assets to someone other than the deceased husband's beneficiaries.
The AB trust is predicated on several principles:
- that each spouse is entitled to the federal estate tax exemption;
- that either surviving spouse has an unlimited marital deduction, allowing the deceased spouse to leave as much property to the surviving spouse without incurring a federal estate tax liability;
- the estate tax exemption and the marital deduction cannot be used on the same property;
- a properly structured trust that receives the property of the 1st-to-die spouse can claim the federal estate tax exemption and, if applicable, the GSTT exemption, while providing support for the surviving spouse by adhering to the following IRS rules:
- the surviving spouse can receive all income from trust, but the surviving spouse's right to spend trust principal is restricted:
- the trust principal can only be spent for the surviving spouse's health, education, support, and maintenance; or
- the trustee, who is usually the surviving spouse, can be given what is called the 5 or 5 power, allowing the trustee to spend the greater of 5% of the trust principal or $5,000, for the benefit of herself or any of the beneficiaries that have been stipulated in the trust document to be eligible to receive any disbursements under the 5 or 5 power.
- the surviving spouse can receive all income from trust, but the surviving spouse's right to spend trust principal is restricted:
The health, education, support, and maintenance requirement is what the tax code refers to as ascertainable standards. Nonetheless, this requirement is hardly restrictive in limiting the money that the surviving spouse can take. Even with the portability option, the main benefits of the bypass trust are that the decedent’s GSTT exemption can be applied to the trust property, any appreciation of property will not be includable in the surviving spouse’s estate, and the remaindermen of the trust cannot be changed, thus ensuring that the decedent’s beneficiaries will receive their gifts.
The Surviving Spouse's Right to Spend Trust Principal is Restricted
The surviving spouse's right to spent principal is restricted because if it wasn't, then the IRS would consider the trust principal to be her money and would be includable in her estate when she dies, thereby losing the deceased spouse's tax exemption on the trust property.
The health, education, support, and maintenance standard is what the IRS calls an ascertainable standard, meaning it must be measurable. Any amount of principal can be spent according to the ascertainable standard. The amount spent for support and maintenance is usually the amount necessary to support the surviving spouse as she was accustomed to living.
The advantage of the 5 or 5 power is that the trust principal can be spent for any reason and can be spent for specified beneficiaries other than the surviving spouse. However, if the surviving spouse lives long enough, then she could spend the entire amount in the trust, leaving little or nothing for the deceased spouse's beneficiaries.
Since one of the benefits of the AB trust is that it prevents the surviving spouse from changing the beneficiaries of the deceased spouse's trust, which is useful if the deceased spouse has beneficiaries that the surviving spouse might not favor, such as children from a previous marriage, then it may make sense to restrict the spending of principal so that there will be at least a certain amount left; otherwise, the benefit of not being able to change the beneficiaries of the trust may become moot, if there is nothing left to distribute. If a spouse wants to be sure that his beneficiaries will receive all of the trust principal, then the trust document can forbid any spending of principal by the surviving spouse for any reason or allow only a set amount of trust principal to be spent, so that the beneficiaries will receive at least a certain amount.
An AB Trust Is Beneficial Only for Legally Married Couples
The AB trust is only tax advantageous for couples that are legally married under federal law — including same-sex marriages. Common-law marriages are also recognized, even if the couple moves to another state that does not have a common-law statute.
There are several types of couples who would probably not want to use an AB trust. Younger couples, for instance, because if one spouse dies prematurely, the other spouse is likely to live for many years afterward and would have to manage the trust for the duration. The same problem would occur if one of the spouses is much younger than the other. If each spouse is independently wealthy, then the surviving spouse would probably not need support, allowing the deceased spouse to leave his property directly to his beneficiaries.
Standard AB Trust
The standard AB trust usually begins as a shared marital trust. When the 1st spouse dies, the marital trust is divided into 2 trusts: Trust A and Trust B. Trust A receives the property of the deceased spouse, but with the surviving spouse named as life beneficiary of the trust while the principal is held in Trust A for the deceased spouse's beneficiaries. The surviving spouse can receive all income from Trust A, and may also receive some principal, if the trust document allows it. With a standard AB trust, when the surviving spouse dies, then the principal of Trust A goes to the beneficiaries of the 1st spouse to die. The property of Trust B goes to the beneficiaries of the surviving spouse. Because the trusts are separate, each spouse can use their estate tax exemption for their trust, so that if the value of the property is less than the exemption in each trust, then there is no federal estate tax on the property.
The reason why the surviving spouse's rights to Trust A is restricted is because if there were no restrictions, then the Internal Revenue Service (IRS) would treat the property in Trust A as the property of the surviving spouse, since she would be using it as if it were her own property — hence, the IRS would include the property in Trust A as belonging to the surviving spouse, and, thus, only her estate tax exemption would be available. Because the surviving spouse has only a life estate interest in the property in Trust A, the principal in Trust A is not entitled to the marital deduction — hence the federal estate exemption amount applies to the property in the trust.
Without using an AB trust, the couple could leave their property to their children as each dies, which would take advantage of the double federal tax exemption, but then it would limit the amount available to the surviving spouse. With the portability option, the deceased spouse can transfer all of his property to the surviving spouse and take advantage of the unlimited marital deduction, but then:
- the exemption under the portability option would not be adjusted for inflation
- if the surviving spouse remarries, then the tax exemption of the predeceased spouse would be lost, and
- the assets of the deceased spouse can be transferred to someone other than the deceased spouse's beneficiaries
Since Trust A becomes irrevocable when it is created, the surviving spouse cannot change the beneficiaries. Other benefits of the AB trust is that assets in Trust A can appreciate free of estate taxes. It can also protect assets if the surviving spouse suffers a catastrophic illness or other financial calamity.
AB Disclaimer Trust
A variation of the standard AB trust is the AB disclaimer trust, which allows the surviving spouse to disclaim any property that is to go into Trust A. A disclaimer is a written declaration by a beneficiary that she declines to accept property left to her, causing the property to go to an alternate beneficiary, which, in this case, is Trust A.
With a disclaimer trust, the surviving spouse can decide how much property she wants to keep for her own benefit or to maximize tax savings. Whatever she disclaims goes into Trust A.
The drawback to the AB disclaimer trust is that if the surviving spouse does not disclaim any property, then there will be nothing in Trust A for the deceased spouse's beneficiaries. However, this would not be a problem if the couple is just going to leave their property to their children.
The main benefit of the AB disclaimer trust over the standard AB trust is that the surviving spouse can maximize tax savings, which will depend on the tax law when the 1st spouse dies. For instance, if the 1st spouse died in 2010, when the estate tax was repealed for 1 year, then the surviving spouse could disclaim all of the deceased spouse's property.
Sprinkling AB Trust
A sprinkling AB trust can also be created that would allow the surviving spouse to use some of the principal in the trust to pay its beneficiaries before the surviving spouse dies, if they need the money sooner. However, the surviving spouse cannot be the trustee; otherwise, the IRS will include the trust property in the surviving spouse's estate and the exemption for the deceased spouse will be lost, thereby negating the tax benefit of the AB trust. The portability option will not be available because it must be chosen when the estate tax return for the 1st-to-die spouse is filed.
Drawbacks of the AB Trust
If the surviving spouse is the trustee of Trust A, then she will have a few duties to perform when her spouse dies. When a standard AB trust is created, the surviving spouse must divide trust property into the respective trusts — new title documents must be prepared and the surviving spouse must obtain a taxpayer ID number for Trust A, maintain accurate financial records, and file an annual income tax return for Trust A. Usually an estate lawyer or accountant will be needed to determine how to best to divide the couple's assets into the 2 trusts.
Records must be kept describing how the surviving spouse is using the property in Trust A. Administrative expenses must be paid. The surviving spouse must also keep 2 sets of books and records — one for her own property and one for Trust A property.
One problem with AB trusts is that there could be a potential conflict of interest between the surviving spouse and the beneficiaries of the trust, especially if the surviving spouse invades the principal for health, education, support, or maintenance, which could consume a considerable amount of principal or even all of it, leaving nothing for the beneficiaries. Conflict could also arise if the surviving spouse becomes incapacitated, and one of the beneficiaries assumes control as trustee, since the beneficiary may be more interested in preserving principal than providing support for the surviving spouse who is nearing the end of her life.
Terminating an AB Trust
An AB trust should be revoked by following these steps: transferring all the trust assets out of the trust into the names of the donors. Create and sign a document revoking the trust. Notify all of the people who know about the trust and the beneficiaries that trust has been revoked.