What Is an AB Trust?

What is a AB Trust

Many different factors are considered when preparing an estate plan, including when beneficiaries will receive their share of an estate and how tax implications will be handled. For many grantors who are interested in trying to avoid paying estate taxes and protecting assets for future beneficiaries, the AB Living Trust is the best avenue to accomplish their goals.

What Is an AB Trust?

An AB trust is a joint trust, usually set up with a married couple, that controls how property is divided after each spouse dies. The purpose of the AB living trust is to avoid paying estate taxes after the first spouse dies. After that first spouse dies, the trust divides into two separate trusts. The first trust is an irrevocable one that is in the name of the deceased spouse. The second trust formed is a revocable one in the name of the surviving spouse. The surviving spouse is allowed to access income during the life time of the surviving spouse from the irrevocable trust, but not the principal, which will be held in trust for the beneficiaries after the remaining spouse dies. During the lifetime of the surviving spouse, the revocable trust can be modified by the surviving spouse as much as she wishes, and she can access the income and principal. As soon as he or she dies, her beneficiaries receive the assets in this trust, as well.

What Are the Differences Between an AB Trust Versus a Simple Trust?

With a simple trust, the assets flow directly and completely to the surviving spouse. That still-living spouse can access all of the money involved without any restriction. The entire trust is still a revocable living trust, meaning that surviving spouse can change the beneficiaries, can move or sell the property involved and can completely get rid of the trust. Alternatively, with an AB trust, only one half of the trust remains revocable and open to modifications by the surviving spouse. The other half becomes irrevocable, meaning the surviving spouse cannot make changes to the beneficiaries, the trust property, and cannot revoke the trust at all.

The AB Trust’s Goal of Reducing Federal Estate Tax

The AB trust was created to reduce the amount of federal estate tax a spouse would need to pay after the first spouse dies. After the first spouse dies, that spouse’s share of the trust passes through to an irrevocable trust, as the surviving spouse never legally owns that property. As an example, if two spouses have a total asset value of $2 million, they would be said to have $1 million each if split evenly. Depending on the federal estate tax exemption, if they split their trust estate properly, no one spouse will own more than what the federal estate tax exemption is. Since the first spouse’s money will go directly to the irrevocable trust, that amount that he or she owned will never be owned by the surviving spouse and will not need to be added to the surviving spouse’s share, making his or her share too high.

AB trusts were very helpful in the past in reducing estate taxes when the federal gift and estate tax exemptions were lower. Today, there is a combined lifetime federal gift tax and estate tax exemption of $5.6 million (as of 2018). Anything that is valued at less than this amount is exempt from federal estate taxes. Most individuals qualify for this amount considering how high it is. In the event this ever changes in the future, this amount may or may not change, making AB trusts more valuable in reducing taxes owed.

What Are the Disadvantages of an AB Living Trust?

The AB trusts do have disadvantages. One of these disadvantages is the fact that the money in the trust estate is not accessible to the surviving spouse in the event he or she needs the money. This seriously limits the financial resources of the surviving spouse, especially if some type of emergency arises. Further, ongoing legal costs are associated with an AB trust since trust must be split after the first spouse dies. In addition, certain additional recordkeeping requirements and tax filing requirements go along with the irrevocable trust making it much more complicated.

Can an AB Trust Be Modified?

If both spouses are still alive, they can make changes to the AB trust, including the decision to revoke it. They are within their rights to transfer any trust property back to their individual names, if necessary, so long as they prepare and sign a document stating that they wish to revoke the trust in full. They can also create a simple revocable living trust in lieu of an AB living trust, which allows the spouses to still avoid probate via a trust but with fewer complications than an AB living trust.

Are AB Trusts Still Useful Today?

In many situations, an AB living trust is still very useful. If an individual wants to ensure that only certain people inherit a portion of that person’s estate. This arrangement is especially helpful since a spouse cannot change the beneficiaries of the irrevocable portion of the trust if any concerns exist that the spouse would try to change the beneficiaries once the other spouse is deceased. The AB living trust preserves at least a portion of the deceased’s estate, keeping the spouse from spending it or using it in any way other than what the deceased spouse intended. An AB living trust is often preferred when the spouses are in a second marriage, and they wish to preserve their assets for their children. In an AB living trust, the surviving spouse can receive the benefits from that property in the irrevocable trust but the remainder of it goes in full to the deceased spouse’s children upon that second spouse’s death.

As of 2011, the federal estate tax exemption was made transferrable between married spouses, which was referred to as the “portability of the estate tax exemption.” This change made it so that if one spouse died after 2011, that spouse’s entire federal estate tax exemption was not needed for the purpose of avoiding estate taxes. If any portion of the federal estate tax exemption was not used by the time the surviving spouse died, that remaining amount could be added to the last spouse to die’s exemption.

AB Trust Diagram
Hw the AB Trust Works (Via Diagram)

An AB living trust is created by two settlor spouses create one trust that is then divided into two separate trusts within the one document, an “A Trust” and “B Trust.” The spouses then divide their assets so that each spouse will have an equal amount of assets in his or her individual name or in the name of his or her respected revocable living trust. It is important that the assets must be divided and not maintained in a joint account to truly create an AB living trust. The “A Trust” is often referred to as the “Marital Trust,” a “QTIP Trust,” or a “Marital Deduction Trust.” The “B Trust” is referred to as the “Bypass Trust,” “Credit Shelter Trust,” or “Family Trust.” The “A Trust” contains the property of the surviving spouse, and the B trust will contain the deceased spouse’s property. The limited control the surviving spouse has will allow him or her to remain in the marital home and still draw income from the trust. After the surviving spouse dies, the assets in the “A Trust” will be subject to estate taxes. The assets in the bypass or “B Trust” will bypass his or her taxable estate after he or she dies.

An example of how an AB Living Trust works would be as following:

James and Theresa are married and have a combined asset value of $12 million. If they did not create an AB Living Trust, when James dies, his half of $6 million would pass to his wife, Theresa. Because of the marital exemption, they would not owe any estate tax. However, when Theresa dies a year later, her taxable estate is $12 million. Therefore, anything that is above the estate tax exemption amount will be taxed. Alternatively, if James and Theresa had create an AB Living Trust, each spouse would leave their half to an irrevocable trust. After James dies, Theresa would receive income from the trust property and would have limited access to the principal that was owned by James. The couple’s children or beneficiaries would inherit the principal in this trust after the Theresa dies. Because Theresa did not technically own the assets in the irrevocable trust created after James died, these assets would not be subject to tax after Theresa dies.

Understanding the AB Trust Step Up Basis

In estate planning, the phrase “step-up” in basis is often mentioned. What a step-up in basis involves is the readjustment of the value of an asset that has appreciated in value, and this readjustment is for purposes of calculating inheritance taxes. When an asset is passed on to a beneficiary, its value normally goes up from when the original owner purchased the asset. This original purchase price is known as the “basis.” In other words, the asset “stepped-up” in value, and the asset will receive a step-up in basis to minimize the capital gains tax the beneficiary would otherwise owe. An example of how this works would be as follows: the testator leaves a beneficiary his or her home in a will. After the testator dies, if the beneficiary had to use the original purchase price or basis in the property, he or she would owe a sizeable capital gains tax bill in the event the beneficiary ever decides to sell the home. However, if the basis is “stepped up,” meaning the asset is valued on the date it is gifted to the beneficiary, then the beneficiary will only owe capital gains taxes based on the difference of the selling price and the stepped-up value. Generally speaking, a beneficiary will receive the “stepped-up” basis on most property transferred to him or her, whether that transfer is done through a trust or a will, and that includes an AB trust.
ABC Trust Diagram
What Is an ABC Trust (Diagram)?

An ABC Trust is similar to an AB trust, but instead of two individual trusts, the trust is divided into three shares upon the first spouse’s death. These shares are called an “A Trust,” “B Trust,” and “C Trust.” The “A Trust” is also known as the “Survivor’s Trust,” which is completely revocable and modifiable by the surviving spouse. The “B Trust” is also known as the “Bypass Trust,” which is irrevocable and cannot be modified after the first spouse’s death. The surviving spouse can receive income from this trust, but it is limited in terms of how much the surviving spouse can get, aside from payment for health, education, maintenance or support. The money from the “B Trust” is part of the taxable estate of the first spouse. The “C Trust” is known as the “Family Trust.” It works much like the “B Trust” and is an irrevocable trust. However, the assets in the “C Trust” are “Q-tipped” (balance of decedent’s assets) to be included as part of the surviving spouse’s taxable estate.

Is a Bypass Trust an Irrevocable Trust?

A bypass trust is an irrevocable trust where the settlor deposits assets into a separate trust, which is meant to pay trust income and principal to the spouse of the settlor for the remainder of the spouse’s lifetime. This bypass transfer is meant to be a tax-free transfer under Marital Deduction laws which allow for an unlimited deduction. When the settlor dies, his or her assets in the bypass trust are not included in the deceased settlor’s estate. This then reduces the total value of the settlor’s estate and reduces the estate taxes owed at the settlor’s death. The bypass trust has also been used as a way to go around gift tax and to minimize taxation of the assets upon the death of a married couple. A bypass trust is another way to describe an AB living trust, which creates an irrevocable trust upon the death of one of the spouses/settlors.

What Is the Purpose of a Disclaimer Trust?

A “disclaimer” trust is one that has provisions that are embedded within the document which allows a surviving spouse to place specific assets under the trust by officially disclaiming ownership of any other portion of the estate. These interests that are disclaimed are then transferred to the trust, without being taxed. In a disclaimer trust, certain provisions can be added to allow for regular payouts from the trust to help support the surviving spouse or minor children of the surviving spouse. An example of a disclaimer trust occurs when someone dies, leaving his or her spouse an estate. That spouse can then disclaim interest in most of the estate, allowing it to pass directly to the trust as if the trust were the original beneficiary, and the trust would make the payouts to the surviving spouse or surviving children. These trusts are also created with the purpose of providing for the surviving loved ones while taking advantage of the tax benefits that go along with the trust.