Tax-Saving AB Trusts

Wealthy married couples get a big tax break when it comes to the federal gift/estate tax. Together, they can transfer over $27 million without owing federal gift tax or estate tax. This ability to combine each spouse's individual estate tax exemption is called (by tax lawyers, anyway) "portability." For most married couples, it eliminates the need to create an AB trust, or bypass trust, to avoid estate tax.

How an AB Trust Works

Under the old tax laws, each spouse had an estate tax exemption, but typically, the first spouse to die didn't use the exemption. That's because most spouses leave everything to the survivor, and bequests to a surviving spouse aren't subject to estate tax. (This rule is called the marital exemption.) But the surviving spouse then owned all the couple's assets. If those assets were over the individual estate tax exemption amount, the estate tax would be owed when the second spouse died.

With an AB trust, instead of leaving their property to each other, both spouses leave their property to an irrevocable trust. The survivor receives any income from trust property and under some circumstances has access to the principal. Typically, the couple's children inherit the property after the second spouse dies. Because the surviving spouse never technically owns the assets in the trust, those assets wouldn't become part of the surviving spouse's estate and aren't subject to tax at the second spouse's death.

You can make a valid living trust quickly and easily with Quicken WillMaker & Trust.

The "Portability" Tax Break

The portability provision (which became effective in 2011) lets the surviving spouse use any part of the total exemption -- $27.22 million for deaths in 2024 -- that isn't used by the first spouse to die. So for most couples, there's no need for an AB trust.

The survivor doesn't automatically have the right to use the deceased spouse's leftover exemption; the surviving spouse must file an estate tax return when the first spouse dies, even though no tax is owed.

AB Trusts: Still Useful for Some

The large personal exemption and portability mean that most couples won't need an AB trust. However, an AB trust might still be useful if:

• You're not legally married. Portability is available only to couples whose marriages are recognized by the federal government. So if you and your partner are unmarried, you won't be able to use your partner's unused personal exemption.
• You want to make sure your children receive your property. Especially if you're in a second marriage, you might want to arrange things so that your surviving spouse can use your property after your death, but that it goes to your children after the second spouse's death. A bypass trust can accomplish that.
• You might owe state estate tax. Some states impose their own estate taxes; these taxes are in addition to the federal estate tax. Exemptions in these states are generally lower than the federal exemption, and most don't offer portability. So if you live in one of these states, your estate might owe state estate tax, even if it doesn't owe federal estate tax.

If you're interested in an AB trust, talk to an experienced estate planning lawyer. These trusts have big benefits, but they have drawbacks, too:

• Restrictions on the surviving spouse's use of the property. The surviving spouse has only limited rights to use trust property in the irrevocable trust.
• Cost. When one spouse dies, the survivor will need to hire a lawyer or accountant to determine how to best divide the couple's assets between the irrevocable trust and the surviving spouse's revocable living trust. How the property is divided can have important tax consequences.
• Trust tax returns. The surviving spouse must get a taxpayer ID number for the irrevocable trust and file an annual trust income tax return.
• Recordkeeping. The surviving spouse must keep separate records for the irrevocable trust property.
• Uncertainty about the tax laws. Because Congress might tinker with estate tax laws again in the next few years, you might end up wanting to change or revoke a trust you create now.

To learn more about bypass trusts, avoiding probate, and many other aspects of estate planning, read Plan Your Estate, by Denis Clifford (Nolo).