AB trust (also called a bypass trust or a credit shelter trust) is a tool used by well-off married individuals to legally maximize their estate tax exemptions. A joint trust founded by a married couple for the aim of avoiding estate taxes is known as an A-B trust. It is created when each spouse contributes assets to the trust and names anyone other than the other spouse as the final beneficiary. The trust takes its name from the fact that when one spouse dies, it splits into two different entities. The survivor’s trust is Trust A, while the decedent’s trust is Trust B.
Understanding an A-B Trust
Estate taxes can bite deeply into a deceased person’s assets. For example, consider a married couple that has an estate worth $20 million by the time one of the spouses dies. The surviving spouse is left with the whole $20 million, which is not taxed due to the unlimited marital deduction for assets flowing from a deceased spouse to a surviving spouse. But then, the other spouse dies, leaving the money to their children. The taxable portion of the estate (the amount that exceeds the 2021 exemption threshold of $12 million; the exemption threshold for 2022 is $12,060,000) will be $8 million.1 This means that $8 million will be taxed at 40%, leaving only $4.8 million for the beneficiaries.
Many married couples set up an A-B trust under their final will and testaments to avoid having their estates subjected to such high taxes. If the couple had an A-B trust instead of a will, the first spouse’s death would not trigger any estate taxes because of the lifetime exclusion. However, a payment equivalent to the present exemption amount will be transferred to the bypass trust, or B trust, which is an irrevocable trust. The decedent’s trust is another name for this trust. The remaining $8 million will be put into a survivor’s trust, or A trust, over which the surviving spouse will have complete power.
Advantages of an A-B Trust
The A trust contains the surviving spouse’s property interests, but they have limited control over the assets in the deceased spouse’s trust. However, this limited control over the B trust will still enable the surviving spouse to live in the couple’s house and draw income from the trust, provided these terms are stipulated in the trust.
While the surviving spouse can access the bypass trust, if necessary, the assets in this trust will bypass their taxable estate after they die. After the surviving spouse dies, only the assets in the A trust are subject to estate taxes. If the estate tax exemption for this spouse is also $12 million for 2021 (the exemption threshold for 2022 is $12,060,000) and the value of assets in the survivor’s trust is still valued at $8 million, none of it will be subject to estate tax.
One must be careful when using bypass trusts and should seek advice from estate experts. The Internal Revenue Service (IRS) requires specific wording in the creation of these trusts and limits on the surviving spouse’s use of the bypass trust. Also, given the high fees involved in planning, managing, and paying for attorney fees for bypass trusts, often a bypass trust may be more costly than the estate tax itself, and sometimes, the estate would incur less taxes outside of the bypass trust by incurring a stepped-up tax basis for property.
The federal tax exemption is transferrable between married couples through a designation referred to as the portability of the estate tax exemption. If one spouse dies, the unused portion of their estate tax exemption can be transferred and added to the estate tax exemption of the surviving spouse.2 Upon the death of the surviving spouse, the property in the decedent’s trust passes tax-free to the beneficiaries named in this trust.
This method of dividing assets may save on estate taxes, but only in limited circumstances. Before the Tax Cuts and Jobs Act, many individuals used this to take full advantage of their estate tax exclusions which were less than $6 million. After the Tax Cuts and Jobs Act, this tool can only be beneficial in limited circumstances because the exclusion now is over $11 million which applies to few individuals. Further, now a spouse’s exclusion is portable, meaning a deceased spouse’s exclusion can be used by the surviving spouse, and this eliminates many of the benefits of a bypass trust. However, many states have no gift taxes or have estate taxes which are not portable which might make bypass trusts still beneficial to wealthy couples.
This is because the B trust uses up the estate tax exemption of the spouse that died first, hence, any funds left in the decedent’s trust will be passed tax-free. As the decedent’s trust is not considered part of the surviving spouse’s estate for purposes of the estate tax, double-taxation is avoided.
Net Worth and A-B Trusts
If the deceased spouse’s estate falls under the amount of their tax exemption, then it may not be necessary to establish a survivor’s trust. The unused portion of the late spouse’s federal tax exemption can be transferred to the surviving spouse’s tax exemption by filling out IRS Form 706.3
While A-B trusts are a great way to minimize estate taxes, they are not used much today. They were popular in the decades around the turn of the 21st century when the estate tax—which hadn’t been adjusted for years—could be triggered on estates as small as $1 or $2 million. Nowadays, each individual has a combined lifetime federal gift tax and estate tax exemption of $11.7 million in 2021, rising to $12.06 million for 2022.45 So only people with estates valued over $11.7 million will opt for an A-B trust in 2021. With the portability provision, a surviving spouse can include the tax exemption of their late spouse, allowing up to $23.4 million as of 2021 and $24.12 million in 2022, which can be transferred tax-free to beneficiaries.
The strategy involves creating two separate trusts after one spouse passes. Usually, the deceased spouse’s portion of the couple’s property, at least up to the applicable exclusion amount ($11.7 million), is put into trust B (the bypass trust). This trust is irrevocable and will pass to beneficiaries other than the surviving spouse (usually their children). The surviving spouse must follow the trust’s plan without overly benefiting from its operation, but this trust often passes income to the surviving spouse to live on for the rest of their life. The surviving spouse’s portion of the property and sometimes the leftover assets of the deceased spouse above the exclusion amount will be put into trust A. The surviving spouse has control over this trust and may use it as they wish. When the surviving spouse passes, both trusts pass to their named beneficiaries.