AB Trust

Article byGayatri Ailani
Edited byShreeya Jain
Reviewed byDheeraj Vaidya, CFA, FRM

What Is An AB Trust?

An AB trust, also known as a marital bypass trust or a credit shelter trust, is an estate planning tool commonly used by married couples to minimize estate taxes. The primary purpose of an A-B trust is to make the most of spouses’ estate tax exemptions, effectively reducing or eliminating estate taxes that would be due upon the surviving spouse’s death.

AB Trust

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The significance of an A-B trust may vary depending on individual circumstances, including the size of the estate and changes in tax laws.  It’s essentially a trust that splits a couple’s assets into two separate trusts upon the death of one spouse. AB trusts are typically used in the United States and are named after sections A and B of the federal estate tax code.

Key Takeaways

  • An AB Trust is an estate planning strategy commonly used by married couples to minimize estate taxes.
  • The primary goal is to maximize spouses’ estate tax exemptions, ultimately reducing or eliminating estate taxes for the heirs.
  • The surviving spouse is typically entitled to receive income generated by the assets in trust B, ensuring they have a stream of income to maintain their standard of living.
  • Creating AB trusts can be complicated and costly.
  • ABC trusts offer more flexibility, and disclaimer trusts provide flexibility for beneficiaries to refuse their inheritance.

AB Trust Explained

An AB trust refers to an estate planning arrangement often used by married couples to minimize estate taxes while preserving assets for their heirs. AB trust structures are typically used in the United States and are named after sections A and B of the federal estate tax code.

Hence, here’s how this trust works:

  • Establishing the Trust: Married couples work with an estate planning attorney to establish an AB Trust as part of their estate plan. This trust can be created through their last will or a revocable living trust.
  • Asset Ownership: The couple divides their assets into two categories:
    • Marital Assets (A): These assets typically include jointly owned property and assets. They are placed in the “A” trust.
    • Individual Assets (B): Each spouse lists assets in their name. These assets go into the “B” Trust.
  • Ab trust after the death of the first spouse: When the first spouse passes away, their assets (from the “B” Trust) and their share of jointly owned property are usually transferred into the “Bypass Trust” or “B” trust.
  • Estate Tax Planning: The assets in the “B” Trust upon the first spouse’s death are designed to use their estate tax exemption. Thus, this effectively shelters these assets from estate taxes upon the first spouse’s death.
  • Surviving Spouse’s Rights: The surviving spouse retains the right to access and benefit from the assets in the “A” trust during their lifetime. Thus, this ensures their financial security and well-being.
  • Flexibility: The specific terms and provisions of this estate planning can vary based on the couple’s preferences and financial situation. It offers flexibility in how income and principal are distributed.

Hence, AB trust planning provides asset management flexibility during the married couple’s lifetimes while ensuring that estate tax exemptions are maximized upon the first spouse’s death.

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Examples

Let us look at AB trust examples to understand the concept better-

Example #1

Suppose John and Jane, a married couple with a combined estate of $10 million, use an AB trust to minimize estate taxes. They split their assets into two trusts:

“A” Trust, which holds jointly owned assets worth $5 million, and the

“B” Trust, funded with $2.5 million from each spouse’s assets.

When John dies, his $2.5 million in individual assets goes into the “B” Trust, using his estate tax exemption. Hence, the remaining assets in the “A” Trust are accessible to Jane without immediate estate tax implications. Upon Jane’s passing, the assets in the “A” trust became tax-exempt. Moreover, the assets in the “B” trust can pass to their heirs tax-free, effectively reducing estate taxes on their $10 million estate.

Example #2

Let’s suppose that Sarah and Michael are a married couple, who have a combined estate valued at $12 million.

The estate tax exemption is $6 million per individual (hypothetical amount).

#1 – Creating The A-B Trust

Trust Establishment: Sarah and Michael work with an estate planning attorney to establish an AB Trust to minimize estate taxes in their estate plan.

#2 – Asset Division

Marital Assets (A Trust): They place jointly owned assets worth $8 million (such as their home, investments, and savings) into the “A” trust.

Individual Assets (B Trust): Each spouse designates $2 million of their assets (e.g., personal investments, retirement accounts) to fund the “B” Trust.

#3 – First Spouse’s Passing (Let’s say Michael passes away)

Upon Michael’s death, his $2 million in individual assets goes into the “B” Trust, using his estate tax exemption.

During her lifetime, Sarah maintains access to and control over the assets in the “A” Trust.

#4 – Surviving Spouse’s Passing (Let’s say Sarah passes away next)

The assets in the “A” trust, initially valued at $8 million, become tax-exempt because Michael’s exemption was applied upon his passing.

Hence, the $2 million in the “B” trust, which used Michael’s exemption, can now pass to their chosen beneficiaries tax-free. Thus, helping reduce estate taxes on their $12 million estate.

Therefore, this hypothetical AB trust structure helps Sarah and Michael preserve their wealth for their heirs while efficiently utilizing both of their estate tax exemptions.

Advantages And Disadvantages

AB trusts, also known as marital bypass or credit shelter trusts, have advantages and disadvantages. Here’s a breakdown of each:

Advantages

  • Estate Tax Savings: One of the primary advantages of this is its ability to maximize the use of each spouse’s estate tax exemption. Therefore, this can significantly reduce or eliminate estate taxes for larger estates, ensuring more assets pass to heirs.
  • Asset Protection: Assets placed in the “B” trust are often protected from creditors and potential lawsuits, safeguarding the inheritance for beneficiaries.
  • Control: The surviving spouse retains control and access to assets in the “A” trust (Survivor’s Trust), providing financial security and flexibility during their lifetime.
  • Privacy: They typically avoid probate, offering more privacy since trust assets don’t become part of the public record.

Disadvantages

  • Complexity: They can be administratively complex and require careful management to ensure they function as intended. Hence, this complexity often involves separate tax returns, which can be cumbersome.
  • Legal and Professional Costs: Establishing and maintaining them can involve legal and professional fees. These costs outweigh the potential tax savings for smaller estates.
  • Rigid Structure: The structure of AB trusts can be inflexible. Once assets are allocated to either the “A” or “B” Trust, it can be challenging to change this distribution, potentially limiting adaptability to changing circumstances.
  • Potential Loss of Step-Up in Basis: When assets are placed in the “B” Trust upon the first spouse’s death, they might not receive a “step-up” in basis to their current market value, which could result in higher capital gains taxes if the assets are later sold.

AB Trust vs ABC Trust vs Disclaimer Trust

The differences between AB trust, ABC trusts, and Disclaimer trusts are as follows:

AspectAB TrustABC TrustDisclaimer Trust
PurposeMinimize estate taxes, provide for the surviving spouse, and preserve assets for heirs.Similar to AB Trust but with additional flexibility and options for asset distribution.Provide flexibility for beneficiaries to disclaim (refuse) their inheritance.
Trust structureD assets into trust A (Marital Trust) for the surviving spouse and trust B (Bypass Trust) for heirs.Adds a third trust, trust C (Survivor’s Trust), which can offer more flexibility for asset distribution.Typically, a single trust structure with provisions allowing for disclaimers.
Tax EfficiencyEffectively utilizes both spouses’ estate tax exemptions by sheltering assets in trust B.These have similar estate tax benefits as marital trusts but may offer more options for asset distribution to optimize tax planning.Primarily focused on flexibility rather than direct estate tax reduction.
Survivor’s ControlThe surviving spouse controls trust A and can access income and possibly principal.These are similar to credit shelter estates. The surviving spouse can control trust C and receive income and principal.Beneficiaries, including the surviving spouse, can disclaim their inheritance, allowing assets to pass to alternate beneficiaries or trusts.

Frequently Asked Questions (FAQs)

1. What is the difference between a QTIP trust and an AB trust?

QTIP trust is designed to provide income for a surviving spouse while maintaining control over the ultimate distribution of assets. In contrast, an AB trust minimizes estate taxes for married couples by optimizing the use of tax exemptions.

2. Why Is an A-B Trust Obsolete?

As changes in tax laws allowed for the portability of the estate tax exemption between spouses, if one spouse passed away and didn’t fully utilize their exemption, the surviving spouse could inherit and use the unused portion, doubling the exemption without needing AB trusts.

3. How can one terminate or modify an AB Trust?

Terminating or modifying these trusts can be complex and require legal proceedings or unanimous consent from all beneficiaries and trustees. Consult with legal professionals experienced in trust administration and estate planning for guidance.

This article has been a guide to what is AB Trust. Here, we explain its advantages, disadvantages, comparison with disclaimer and ABC trusts, and examples. You may also find some useful articles here –

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