A-B Trusts, commonly known as joint trusts, are a financial instrument established by a married couple to reduce estate taxes after their demise. The concept involves each spouse placing assets into the trust and designating a final beneficiary, excluding the other spouse. The trust then divides into Trust A (survivor’s trust) and Trust B (decedent’s trust) upon the death of one spouse.
Although A-B trusts are known for their tax-minimizing trait, their popularity has staggered with the increase in estate tax exemption limits covering most estates. To illustrate this, consider a hypothetical couple with an estate worth $20 million. When one spouse dies, the surviving partner inherits the whole amount with no tax penalties, thanks to the unlimited marital deduction. However, upon the passing of the second spouse, the heirs would need to pay a 40% tax on any amount above the $15 million exemption threshold, leaving them with $17 million of the original $20 million.
In an effort to avoid significant tax hits like these, many couples established A-B trusts. In our example, had the couple set up an A-B trust, the estate would escape taxes upon the first spouse’s death, thanks to the lifetime exclusion.
The trust setup would entail transferring the exempted amount ($15 million) to an irrevocable trust (B trust or bypass trust). The remaining $5 million would move to the survivor's trust (A trust), over which the surviving spouse would have complete control. The applicable estate tax would be deferred until the second spouse's death.
However, the necessity of the A-B trust is negated if the surviving spouse opts for portability of the first spouse’s unused exemption. This scenario involves the entire $20 million estate being passed down tax-free, as the couple's combined exemption would be $30 million.
Assets in Trust B are beyond the surviving spouse's total control, but they retain limited control to live in the couple's property and draw income, as stipulated in the trust. Whilst the surviving spouse can access the B trust, these assets bypass their taxable estate, thereby subject to no estate taxes after the second spouse's death.
A-B trusts offer several advantages, such as death tax exemptions, in-built trust protection, and portability of exemptions. However, they do require maintenance, come with a complex structure and may lead to substantial capital gains taxes after both spouses pass away. Although not as prevalent as they were once, A-B trusts, also known as bypass trusts or credit shelter trusts, still serve a purpose in estate planning, especially for estates exceeding the estate tax exemption limit. Thus, it would be beneficial to consult a financial advisor to explore ways to minimize taxes while passing on assets to heirs.