The purpose of an A/B Trust is to save estate taxes
(death taxes) which are assessed by the IRS at the time of death.
An A/B Trust only works if you are married at the
time of your death. Here is how.
First some basics:
The federal government allows every person to give away,
either through lifetime gifts or upon death a certain amount of money
(currently $1,500,000) without being taxed. The $1,500,000 per person is increased to
$2,000,000 in year 2006, and $3,500,000 per person in year 2009. This is known as your
Lifetime Exemption. (Currently, the Lifetime Exemption will revert back to $1,000,000 per
person in 2011, unless Congress permantly repeals the estate tax before then.
Any assets exceeding this (current) $1,500,000 are then taxed at a progressive Estate
Estate and Gift
beginning at around 37%, with the highest rate around 48% of every dollar above $1,500,000.
Also, the Internal Revenue Code allows any married person to gift, or leave at death, to
their spouse an unlimited amount of assets - millions or billions, it doesn't matter. This is called
the Unlimited Marital Deduction.
Married couples typically have reciprocal Wills which give their property to the other spouse,
with the assets going to the children after the Surviving spouse's death. This procedure wastes
the first to die spouse's Lifetime Exemption, and "overfunds" the Surviving Spouse's estate.
The use of an A/B Trust prevents this "overfunding of the estate",
and uses both lifetime exemptions, effectively shielding $3,000,000 (this limit is being by
using both spouse's Lifetime Exemptions.
(Obviously, the first to die spouse could easily provide
in the Will that assets should go
directly to the children, and not to the Surviving Spouse.
However, this is usually (a) not
desired, (b) not practical when the children are minors,
young adults, or not even born, (c)
assurance is required that the Surviving Spouse is
adequately protected through his or her
lifetime, and (d) avoids the high cost of probate.)
Here is what happens if Husband and Wife have no A/B Trust:
Assume the following facts:
Husband and Wife have assets worth $3,000,000. Husband
dies, and leaves everything to Wife. This is the manner most married couples leave their
property through their Will, so that the surviving spouse has use of all assets,
and that at the surviving spouse's death all of the assets
will be gifted to the couples' children. At
Husband's death, there are no taxes due because of
the Unlimited Marital Deduction.
Assume the Wife dies next year, with the Lifetime Exemption still being $1,500,000.
Wife dies leaving everything to her children.
Of the $3,000,000, Wife's Lifetime Exemption protects $1,500,000, leaving the upper
$1,500,000 subject to the Estate Tax over the $1,500,000
Unified Credit. At our current tax level,
Wife's estate will have to pay tax on the $1,500,000, some $600,000 in estate taxes.
The children get $2,400,000. Had the couple had an A/B Trust, there would have been no
estate tax (see why below) and the children would have gotten the full $3,000,000.
What happened in this scenario is that Husband and Wife wasted Husband's $1,500,000
Lifetime Exemption. The couple has, what is called, overfunded
Wife's Estate by wasting Husband's $1,500,000 Lifetime Exemption.
Here is what happens with an A/B Trust.
Same facts as above, with Husband and Wife having assets worth $3,000,000. Husband
and Wife have an A/B Trust in which Husband and Wife hold all of their assets in
trust for their own benefit during their lifetimes. The Trust can be revoked, modified, added to
or amended at any time. Husband and Wife conduct their business and personal finances
essentially as if the Trust were not in existence, except that their real estate holdings, securities
and other assets are held in the Trust name.
At Husband's death, the Trust will be divided into two trusts;
one trust we will call the
Decedent's Trust and the other we will call the Survivor's Trust.
The Decedent's Trust will contain a certain amount of assets, determined by a formula,
but not to exceed $1,500,000. Since we can place almost any type of assets into this Decedent's
Trust, we will fund Decedent's Trust with the appreciating assets, such as
securities, maybe a growing business, real estate, etc. The remaining $1,500,000 goes to the
During Wife's lifetime, she does not own the assets in
Decedent's Trust; however, she has
access to these assets for her "education, support, health and
maintenance". If the assets placed in Wife's Survivor's Trust are, or become at
any time insufficient to maintain Wife in her accustomed
manner of living, she has access to the funds in Decedent's Trust.
At Wife's death, the $1,500,000 that were attributed to the Husband are
assets still owned by Decedent's
Trust, and thus are not included in Wife's
estate. When these assets pass to the couples' children,
Husband's $1,500,000 Lifetime Exemption
protects these assets from federal estate taxes.
The assets remaining in Wife's Survivor's Trust ($1,500,000 at her death) are also
transferred free of tax because Wife is using her $1,500,000 Lifetime Exemption. As you can see,
both Husband and Wife's Lifetime Exemption were used.
The entire $1,500,000 is passed free of tax, and the children have
$600,000 more than if their parents had not set up an A/B Trust.
As a last note, many couples do not think that
their estate will exceed $1,500,000 at their death
to justify the use of an A/B Trust. However, inflation has
effectively pushed many estates' values above this
benchmark. For instance, a house worth
$150,000 ten years ago may be worth $1,500,000 now. Furthermore, a
couple may have a life insurance policy
which provides for a death benefit of $1,000,000, which
will be included in the couple's estate.
Property which may have a nominal value to the Husband and
Wife may have an entirely higher
fair market value when appraised by the IRS at its "highest and
best use". The couple may get an unexpected financial windfall, such as
lottery winnings, proceeds from a lawsuit, or inheritance. Thus,
often a couples' actual estate at the time of the
second spouse's death is much higher than first
expected, and an A/B Trust is necessary to avoid or reduce federal estate taxes.
As a rule of thumb, with married couples it is most prudent to use an A/B Trust to
anticipate all contingencies. There is no real downside, and
there are existing or potential upsides to using a Marital Deduction Trust.