Do I Still Need an AB Trust?

It depends. . .

This article is for educational purposes only.  Your attorney should help you decide whether you need an AB Trust.  The decision on whether to keep or replace an AB Trust is highly fact specific and subject to your personal goals and risk tolerance.

AB Trusts are very common estate plans, because prior to 2012, the only sure way for a married couple to both use their Federal Estate Tax Exemptions, through a trust, was by the use of an AB Trust.  However, a major change in the Federal Estate Tax Law in 2012 gave married couples more options for their estate plan.  Estate plans that have an AB Trust should be reviewed by an estate planner to determine if an AB Trust is still the best option.

How Does an AB Trust Work?

In general, upon the death of the first spouse in an AB Trust, two subtrusts are created: Trust A (the Survivor’s Trust, holding the surviving spouse’s property); and Trust B (the Bypass Trust, holding the deceased spouse’s property). The deceased spouse’s Federal Estate Tax Exemption is used to fund Trust B, the Bypass Trust.  The reason Trust B had to be created to hold the deceased spouse’s property was because the Federal Estate Tax Exemption was like a use-it-or-lose-it coupon.  The coupon had to be used at the time of death or it could not be used at all.  As a result, the AB Trust used the first deceased spouse’s Federal Estate Tax Exemption when the first spouse died, and the surviving spouse’s Estate Tax Exemption was used later when the surviving spouse died.

What Changed?

In 2012, a major change in the law now allows a surviving spouse to claim the deceased spouse’s Estate Tax Exemption (referred to as portability).  Now, the tax coupon is not a use-it-or-lose-it coupon.  The surviving spouse can now use his or her coupon and their Deceased Spouse’s Unused Exemption (“DSUE”).  This change in the law makes Bypass Trusts optional because the surviving spouse can use both of the couple’s Federal Estate Tax Exemptions.

Why Does This Change Matter?

The change in the law can help couples avoid passing capital gains taxes onto their beneficiaries. Inclusion of an asset in a decedent’s estate allows for a step up in the basis of that asset.  The step up in basis can eliminate or reduce the beneficiary’s capital gains taxes.  This example is specific to California, a community property state with no estate taxes:

When Husband dies, his share of the community property and his separate property are passed to Wife.  As a result, all of Husband’s and all of Wife’s community property get a step up in basis to the current fair market value.  Husband’s separate property given to Wife also receives a step up in basis to the current fair market value.  When Wife dies, all of Husband’s property is included in her taxable estate, so all of the property gets a second step up to the current fair market value before it is passed to the beneficiaries.

The beneficiaries can avoid paying capital gains taxes when they sell the property, and Wife can avoid Federal Estate Taxes by using her Federal Estate Tax Exemption and her Deceased Spouse’s Unused Exemption.

How is the AB Trust Unable to Avoid Capital Gains Taxes?

The AB Trust uses the first deceased spouse’s Estate Tax Exemption to fund the Bypass Trust.  The assets that are placed into the Bypass Trust are not included in the surviving spouse’s taxable estate. As a result of the non-inclusion of the assets in the surviving spouse’s taxable estate, the assets in the Bypass Trust only get one step up in basis when the first spouse dies.  When the assets come out of the Bypass Trust upon the death of the surviving spouse, the beneficiaries may pay a capital gains tax on the growth in value of the assets during the period of time that they were in the Bypass Trust.  If the Bypass Trust is not funded carefully and if the spouses die many years apart, the assets in the Bypass Trust could grow significantly and create a large capital gains tax that the beneficiaries would be responsible to pay.  

So, Should I get rid of my AB Trust?

It depends, talk to an attorney.  An AB Trust has its benefits and drawbacks and there are still many good reasons to have an AB Trust.  In addition, capital gains taxes are just a possible product of an AB Trust, not a certainty.  An alternative to an AB Trust can eliminate capital gains taxes, but the alternative has its benefits and drawbacks as well.  As a result, the decision to keep or get rid of an AB Trust is highly personal and fact dependent.  The best way to determine if an AB Trust is still the best option for you is to meet with your estate planner.

If you are unable to meet with your estate planner, Timothy Follett at Santa Barbara Estate Planner will review your existing estate plan and counsel you on your options so you can make an informed decision about the future of your AB Trust.   

tim@santabarbaraestateplanner.com    https://santabarbaraestateplanner.com/    (805) 669-7009