Trusts are intricate legal instruments designed to safeguard assets, provide for beneficiaries, and manage estates efficiently. Among the various types of trusts, the Credit Shelter Trust, informally known as the AB Trust, was the standout tool for married couples to reduce the implications of Federal Estate Tax (FET) for their families.
Mechanism of AB Trusts
By using this language and form of trust, the married couple used each of their lifetime exemptions when creating the trust, rather than having it applied at their death. Without the AB Trust, due to the unlimited marital deduction where a married couple can pass an unlimited amount of assets between each other without triggering the tax, a married couple would only utilize the surviving spouse’s exemption.
Consider a typical married couple worth two million dollars or one million each. At the first death, the entirety of the estate passes to the surviving spouse, now worth the full two million. Twenty years ago, this was a problem, when the surviving spouse only had an exemption amount of one million and was worth two million when they died, the children then owed 50% FET of the amount more than the exemption, in this case, five hundred thousand dollars, due within nine months of the date of death. This huge tax often resulted in the forced liquidation of an estate, a fire sale, just to create the liquidity to pay the tax bill.
Benefits and Challenges of AB Trusts
When utilizing the AB Trust, the exemption was effectively doubled. Each spouse would use their exemption amount when creating the trust so the trust owned the full two million and when the first spouse died, they owned nothing and when the surviving spouse died, they owned nothing, the trust owned it all and the trust did not die. Since the tax rate was 50% and the first spouse did not own anything, and the surviving spouse did not own anything, the tax was 50% of zero or just zero. The family saved $500,000 in this example.
The saving was accomplished by splitting the trust into two parts upon the death of the first spouse: the A trust (also known as the Survivor’s Trust, Marital Trust, or QTIP Trust) and the B trust (also known as the Bypass Trust or Credit Shelter Trust). While AB provisions have long been favored for their tax benefits, within the realm of marital trusts, the concept of AB provisions can add another layer of complexity that modernly is often regretted by the surviving spouse. This is especially true in light of recent changes in tax laws and evolving estate planning strategies prompting some married couples to reconsider their trust structures.
Modern Estate Planning Considerations
For starters, the complexity associated with managing two separate trusts under AB provisions can pose administrative burdens and limit flexibility for surviving spouses and beneficiaries. With assets divided between the A and B trusts, managing investments, distributions, and tax filings can become cumbersome, potentially outweighing the tax benefits in some cases.
Changing Tax Laws and Increased Exemptions
Another significant development in estate planning that has influenced the removal of AB provisions is the increase in the federal estate tax exemption. Over the past several years, the estate tax exemption amount has risen substantially, reaching multi-million dollar thresholds. As a result, fewer estates are subject to federal estate taxes, rendering the traditional AB provisions less necessary for many couples.
Simplifying Trust Structures
In response to these changing dynamics, many married individuals and their advisors are opting to simplify their trust structures by removing the AB provisions altogether. By consolidating the A and B trusts into a single unified trust, known as a “portability trust” or “unified credit trust,” couples can streamline administration, enhance flexibility, and adapt more efficiently to evolving tax laws and personal circumstances.
Steps for Removing AB Provisions
The removal of AB provisions requires careful consideration and strategic planning to ensure that the trust continues to align with the grantors’ goals and objectives. Key steps in this process typically include:
- Reviewing Estate Planning Goals: Before making any changes to the trust, it’s essential to revisit the grantors’ original estate planning goals and objectives. Understanding the intended purpose of the trust and the needs of the beneficiaries will guide the decision-making process.
- Assessing Tax Implications: While the primary motivation for removing AB provisions may be to simplify administration, it’s crucial to assess the potential tax consequences of such a decision. Consulting with tax professionals can help evaluate the impact on income taxes, capital gains taxes, and any remaining estate tax considerations.
- Amending Trust Documents: Once the decision to remove AB provisions is made, the trust documents must be amended accordingly. This process involves drafting and executing legal documents that reflect the desired changes to the trust structure, including the consolidation of assets and the modification of trustee powers and beneficiary designations.
- Timing and Competence: Most importantly, in the majority of instances, this can only be accomplished while both spouses are alive and remain competent to amend their trusts and estate plans. Following the death of the first spouse, the surviving spouse is often surprised to learn that the trust has become partially irrevocable and the “B” provisions can no longer be amended.
Potential Changes in Tax Laws
The Tax Reform Act of 2018 was passed in Congress through a compromise referred to as a sunset provision. The 2018 framework sunsets or goes away if Congress doesn’t change it or make it permanent by the deadline, in this instance, 12/31/2025. No one knows what will happen at that time, but there are a couple of things we do know:
- If Congress votes to maintain it, even with some modifications, it is likely to include provisions which will cover the majority of married households.
- If the law is allowed to sunset, the individual lifetime exemption will return to its pre-2018 level of six million, then adjusted for inflation; an amount covering 85%+ of America.
- The portability of the lifetime exemption will remain in place. Portability in this instance means that the surviving spouse can use the unused portion of the deceased spouse’s lifetime exemption. An example would be if the couple were worth six million at the first death and the surviving spouse grew the estate to nine million prior to their death, the surviving spouse’s estate uses the unused portion of the decedent spouse’s exemption. This effectively doubles the individual exemption to twelve million and enough for this nine million dollar estate to avoid FET.
For many married couples, AB Trust provisions are no longer necessary. Those married couples who utilized such trusts from the 1990s through 2018 should have their trusts reviewed with their estate planning attorney considering these changed circumstances.
If you have an AB Trust and are considering updating your estate plan considering recent tax law changes, now is the time to act. Contact the Law Offices of David R. Schneider, APC to review and potentially revise your trust to ensure it aligns with your current financial goals and circumstances. Our experienced team is here to provide you with the guidance and support you need to navigate these complex decisions.