A common estate planning technique for married couples is the A/B Trust. Upon the death of the first spouse, an A/B Trust will subdivide into two sub-trusts: a revocable A Trust to hold the surviving spouse’s share of the estate and an irrevocable B Trust to hold the deceased spouse’s share of the estate. There are typically three main reasons for married couples to structure their trust in this manner.
1. Estate Tax
For many years, the most common reason for the A/B Trust structure was planning for the estate tax which is a tax on inheritance. While the estate tax rate has varied over the years, it had been as high as 55%.
However, each individual has an estate tax exemption: an amount of assets that are exempt from the estate tax upon death. The exemption has changed over time, slowly rising from $600,000 in 1997 to $5,430,000 in 2015.
When the estate tax exemption was lower, an A/B Trust structure was a popular estate tax planning device because it allowed married couples to combine their estate tax exemptions. For example, if a couple in 1997 had an estate worth $1,000,000, one spouse’s estate tax exemption ($600,000 at the time) would not be enough to prevent application of the estate tax and the $400,000 difference would be taxed at an extraordinary rate. With an A/B Trust structure that allows both spouses to combine their estate tax exemptions, the entire estate would be free from estate tax because the married couple jointly would have $1,200,000 worth of estate tax exemption.
In 2015, with the estate tax exemption at $5,430,000 per person, few married couples need an A/B Trust structure for estate tax purposes because one spouse’s exemption is often enough to cover the entire estate. Furthermore, other tools such as “portability” have been introduced to make A/B Trusts less relevant for estate tax purposes to the vast majority of estates.
Independent of any estate tax concerns, some married couples still like the concept of an A/B Trust structure because they are worried that a surviving spouse might change the beneficiaries of the trust after the death of the first spouse. This is a common concern with blended families where there are separate children of one or both spouses. This is also a concern even when there are joint children as some people worry that a surviving spouse might lose mental capacity and be subject to undue influence to change the agreed upon estate plan.
While the surviving spouse will generally have the authority to modify the provisions of the revocable A Trust, the surviving spouse will often be prevented from changing the beneficiaries of the irrevocable B Trust after the death of the surviving spouse. Furthermore, an A/B Trust can be designed to limit the surviving spouse’s access to the B Trust or can require that a child of the deceased spouse or other trusted individual serve as co-trustee or sole trustee of the B Trust. The idea is to provide a lifetime benefit to the surviving spouse with respect to the deceased spouse’s share of the estate, but ultimately ensure that the deceased spouse’s beneficiaries receive the intended inheritance after the death of the surviving spouse.
3. Asset Protection
With the high number of lawsuits that are filed each year, and the fact that the number one reason for bankruptcy in the United States is unpaid medical bills, many people are worried about asset protection. The general rule in California, as with most states, is that individuals cannot create trusts for themselves with their own assets and give themselves asset protection.
However, if structured properly, individuals can create trusts for third parties that provide a significant degree of asset protection. The B Trust is a trust established by a third party (the deceased spouse) for the benefit of the surviving spouse. As a result, if structured properly, the A/B Trust structure can provide the surviving spouse with a degree of asset protection.
A Twist on the A/B Trust
While many couples may feel that the A/B Trust structure is no longer necessary for estate tax purposes, they might still like the control or asset protection features. However, in such a situation, a traditional A/B Trust structure might not be ideal.
With a traditional A/B Trust, the B Trust is designed to utilize the deceased spouse’s estate tax exemption, often mitigating or eliminating the application of the estate tax. This estate tax benefit comes with a catch: assets held in the B Trust will not receive a “step-up” in basis for capital gains tax purposes upon the death of the surviving spouse.
As a result, the children or other remainder beneficiaries of a B Trust are often forced to realize significant capital gains tax on securities or real property if there was significant appreciation between the death of the first spouse and the death of the surviving spouse.
If it is a choice between the application of the estate tax and the application of the capital gains tax, then typically the capital gains tax is the better tax. However, for the vast majority of estates where there will be no estate tax regardless of whether there is a traditional A/B Trust structure because of today’s very high estate tax exemption, a traditional A/B Trust structure can unnecessarily cause higher capital gains tax.
One popular solution is to structure an A/B Trust with a “Clayton Election.” The idea behind the Clayton Election is to still require an A/B split. However, the surviving spouse is given the option to choose the tax treatment of the B Trust: either keep it as a traditional B Trust which provides estate tax protection but often results in higher capital gains tax, or treat it as a “QTIP Trust” which does not provide estate tax protection but is more favorable with respect to the capital gains tax.
With the dramatic changes in estate tax laws over the past decade, married couples should reevaluate whether they need or want an A/B Trust structure. One option would be to entirely eliminate the A/B Trust structure. However, if there is concern or interest in control or asset protection, then perhaps a Clayton Election is preferable to a traditional A/B Trust structure.
KRASA LAW, INC. is located at 704-D Forest Avenue, Pacific Grove, California and Kyle may be reached at 831-920-0205831-920-0205.
Disclaimer: This article is for general information only. Reading this article does not establish an attorney/client relationship. Before acting on any of the information presented in this article, you should consult a competent attorney licensed to practice law in your community.