The federal gift and estate tax is effectively a tax on the transfer of wealth that is collected from your estate after you die. Every estate is potentially subject to federal gift and estate taxes. In addition, a handful of states, including Illinois, also impose a state-level estate tax. Collectively, gift and estate taxes can significantly diminish the value of the estate you pass down to loved ones which is why many people choose to incorporate tax avoidance tools and strategies into their overall estate plan. A Waukegan estate planning attorney at Hedeker Law, Ltd. explains how an AB trust might be able to help your estate avoid, or at least diminish, the amount of taxes the estate owes.
AB Trust Basics
Traditionally, an AB trust was used as an estate planning tool to maximize federal and state exemptions to gift and estate taxes. The “A Trust” is also commonly referred to as the “Marital Trust,” “QTIP Trust,” or “Marital Deduction Trust.” The “B Trust” is also commonly referred to as the “Bypass Trust,” “Credit Shelter Trust,” or “Family Trust.” An AB trust system is set up within your Last Will and Testament or in a revocable living trust.
The Lifetime Exemption, the Marital Deduction, and Portability
Every taxpayer is entitled to make use of the lifetime exemption to reduce the amount of gift and estate taxes owed by their estate. Like the tax rate, the exemption amount also fluctuated wildly prior to the passage of ATRA. Ultimately, ATRA set the lifetime exemption amount at $5 million, to be adjusted for inflation each year. For a married taxpayer with assets valued above the Lifetime Exemption amount, there was always the unlimited marital deduction. A married taxpayer can use the unlimited marital deduction to leave an unlimited amount of assets to a spouse tax-free. Historically, the problem with using the marital deduction was that it often over-funded the spouse’s estate which effectively only delayed the payment of estate taxes. The solution to that problem was portability. Portability refers to a surviving spouse’s ability to use any unused portion of a deceased spouse’s lifetime exemption.
How Does an AB Trusts Fit In?
The AB trust concept was originally designed to resolve the over-funding problem that the marital deduction often created. With the advent of portability, it may seem as though the need for an AB trust has disappeared. Not necessary so. If you have different final beneficiaries than your spouse because this is a second (or subsequent) marriage for you, you may still benefit from an AB trust. In addition, couples who live in states where an estate tax is imposed may still need an AB trust because not all states have embraced the concept of portability.
How Does an AB Trust Work?
An AB trust system is established in your Will or a revocable living trust. You and your spouse divide your assets so that you each have approximately the same amount of assets in your name (or in the name of the trust you created). If you are the first spouse to die, the current lifetime exemption amount would be funded into the B Trust. This uses your lifetime exemption from federal estate taxes. The B Trust can be relatively flexible and used for the benefit of the surviving spouse and descendants or other beneficiaries. Any excess assets are funded into the A Trust. This will defer the payment of estate taxes on the assets above your lifetime exemption until after the death of your surviving spouse. Due to this estate tax deferment, the A Trust is less flexible and can only be used for the benefit of the surviving spouse. In addition, federal law requires that the surviving spouse must receive all of the income from the A Trust in order for it to qualify for the unlimited marital deduction.
When your surviving spouse later dies, he/she will still be entitled to use his or her own lifetime exemption with anything leftover being subject to taxation. The assets remaining in the B Trust pass estate tax-free to the final beneficiaries. This is because the B Trust used up the federal exemption of the first spouse to die, so anything left in the B Trust will pass estate tax-free. This is where the benefit of an AB trust comes in by potentially providing a windfall to the final beneficiaries if the surviving spouse does not need to use the assets from the B Trust and they continue to grow in value during the surviving spouse’s remaining lifetime. If there are assets left in the A trust after paying any taxes due, those assets pass to the final beneficiaries which may not be the same beneficiaries as the B trust beneficiaries.
Contact a Waukegan Estate Planning Attorney
For more information, please download our FREE estate planning worksheet. If you have additional questions or concerns about how an AB trust might fit into your estate plan, contact an experienced Waukegan estate planning attorney at Hedeker Law, Ltd. by calling (847) 913-5415 to schedule an appointment.