Do You Still Need an AB Trust in Your Estate Plan?

If the last time you and your spouse updated your estate plan was more than a decade ago, your plan may contain what is sometimes referred to as AB trust planning. Before portability became available in 2011, AB trusts were commonly used to help married couples take advantage of both spouses’ federal estate tax exemptions.

Today, an AB trust should not automatically be removed simply because portability is available. However, an older AB trust may create unnecessary administrative burdens or unfavorable capital gains tax consequences. Whether the plan should be kept or revised depends on your assets, beneficiaries, tax exposure, and estate planning goals.

What Is an AB Trust?

An AB trust structure helps married couples reduce estate taxes and control the distribution of the property and accounts owned by the first spouse to die.

When the first spouse dies, their assets are divided between two subtrusts:

• Trust A, sometimes called a marital or QTIP trust, holds property for the surviving spouse and avoids estate taxes by using the unlimited marital deduction.
• Trust B, sometimes called a bypass, family, or credit shelter trust, holds the deceased spouse’s assets for the surviving spouse, other beneficiaries, or some combination of the two. It uses the deceased spouse’s available estate tax exemption to minimize estate taxes.

This setup can help keep money protected and ensure that it ultimately goes to the intended beneficiaries.

Why Were AB Trusts Common Before Portability?

Before 2011, if a married person died without using their federal estate tax exclusion, the unused portion was generally lost. AB trust planning provided a way to preserve the first spouse’s exemption instead of allowing it to go unused.

That changed in 2011, when portability of the federal estate tax exemption between spouses was introduced.

Portability allows a surviving spouse to use the unused portion of their deceased spouse’s federal estate tax exemption. If the first spouse’s taxable estate is below the exemption limit or passes entirely to the surviving spouse under the marital deduction, the unused exemption may be transferred, or “ported,” to the surviving spouse.

Portability is not automatic. The deceased spouse’s estate must generally make a portability election by filing a timely federal estate tax return. When the election is properly made, the surviving spouse may use their own federal estate tax exemption plus the unused exemption ported from the deceased spouse.

The good news is that portability has been made a permanent part of federal estate tax law. The bad news is that the AB trust planning in an older estate plan may now do more harm than good.

How Does Portability Work?

Take, for example, hypothetical Fred and June, who have been married for 40 years.

If Fred dies and none of his federal estate tax exemption is used, June may be able to add Fred’s unused exemption to her own by having Fred’s estate file a timely federal estate tax return and make the portability election.

If June subsequently dies, she may have Fred’s unused exemption plus the federal estate tax exemption available to her at that time. The exact amount will depend on the federal estate tax laws in effect and how much of either spouse’s exemption has already been used.

In addition, accounts and property passing outright to June from Fred’s estate or revocable trust, or passing to her by right of survivorship, generally receive a basis adjustment to their fair market values as of Fred’s date of death. This is usually called a step-up in basis because property generally increases in value over time.

What Problems Can an Older AB Trust Cause?

Now consider what could happen if Fred and June have a typical estate plan from the 1990s that uses an AB trust structure to ensure full use of both spouses’ federal estate tax exemptions.

If they neglect to update that plan and Fred dies, June may be left managing two subtrusts drafted around decades-old planning priorities. Their beneficiaries may also receive no additional step-up in income tax basis for the accounts and property remaining in the B trust when June dies.

Instead, the beneficiaries may inherit the B trust’s accounts and property with a basis tied to the value established at Fred’s death. If June lives for many more years and the property continues to appreciate, the beneficiaries could face a substantial capital gains tax bill when they eventually sell the inherited property.

Fred and June’s story is only one possible scenario, but it illustrates one of the potential disadvantages of keeping an older AB trust plan without reviewing it under current law.

Are AB Trusts Still Necessary?

Portability has reduced the need for married couples to use AB trusts solely to preserve both spouses’ federal estate tax exemptions. However, that does not mean every AB trust is now unnecessary.

Whether an AB trust is still appropriate depends on why the trust was created, the couple’s current assets, their intended beneficiaries, and their broader estate planning goals.

An older AB trust may no longer provide the tax advantages it was originally designed to create. In some circumstances, it may also result in unnecessary trust administration or less favorable income tax treatment for the beneficiaries.

That is why the decision should be based on a review of the actual trust documents and the family’s current circumstances, not simply on the age of the plan.

When Can an AB Trust Still Be Beneficial?

There are still good reasons for some married couples to keep AB trust planning in an updated estate plan.

A two-subtrust structure can provide for the surviving spouse in a tax-efficient way through one subtrust while allowing different beneficiaries to benefit from the accounts and property held in the other subtrust.

It can also allow the first spouse to determine who will ultimately receive certain property instead of leaving all distribution decisions to the surviving spouse. This may be particularly important when spouses have different beneficiaries or want to balance the needs of a surviving spouse with those of children or other family members.

An AB trust may therefore continue to serve important planning goals even when it is no longer needed solely to preserve the federal estate tax exemptions of both spouses.

How Does an AB Trust Affect Capital Gains and Basis?

The income tax basis of inherited property can have a significant effect on the amount of capital gains tax owed when the property is later sold.

Property included in a person’s taxable estate generally receives a basis adjustment at that person’s death. Property held in a B trust, however, may not receive another basis adjustment when the surviving spouse later dies because the property may not be included in the surviving spouse’s estate.

If the property appreciates significantly between the deaths of the two spouses, the beneficiaries may inherit it with a lower basis and face a larger capital gains tax bill when they sell it.

This does not necessarily mean that a B trust is a poor choice. It means that basis planning should be considered alongside estate tax planning, control of the property, beneficiary protection, and the couple’s other goals.

Should You Keep, Amend, or Remove an AB Trust?

There is no single answer that applies to every married couple.

An existing AB trust may still accomplish important family, tax, or asset-protection goals. In other cases, the plan may be based on outdated tax laws and create complexity or tax consequences the couple no longer wants.

If you are married and your estate plan is more than a few years old, it is worth having the plan reviewed. Your existing estate plan may be revised to preserve the favorable features of AB trust planning while also taking advantage of portability, current estate tax laws, and basis-adjustment planning.

Andre O. McDonald is an estate planning, special needs planning, and Medicaid planning attorney serving Howard County, Montgomery County, and the District of Columbia. To discuss whether an AB trust still makes sense for you and your family, call McDonald Law Firm at 443-741-1088, 301-941-7809, or 202-640-2133.

DISCLAIMER: THE INFORMATION POSTED ON THIS BLOG IS INTENDED FOR EDUCATIONAL PURPOSES ONLY AND IS NOT INTENDED TO CONVEY LEGAL, INSURANCE, OR TAX ADVICE.