When planning to reduce federal estate taxes, married couples can make use of the AB Trust system in their estate planning. The AB Trust is set up in such a way that they can effectively transfer two times the maximum federal estate tax exemption to their heirs without encountering federal estate tax penalties. However, in states that collect separate estate tax, traditional AB Trust planning can cause part of the B Trust to be taxed when the first spouse dies.
Enter the ABC Trust system of estate planning for married couples, also known as "gap trust planning" and making the "state QTIP election." A handful of states allow the payment of both federal and state estate taxes to be deferred until after the surviving spouse's death.
So let's take a look at how an ABC Trust plan may work for your estate.
Traditional AB Trust Planning
In order to understand how the ABC Trust system works, you'll first need to understand how the AB Trust system works.
If a married couple has an AB Trust estate plan when the first spouse dies an amount equal to the federal estate tax exemption will be funded or moved into the B Trust, and anything over this amount will remain as the A Trust.
What does that accomplish? It uses up the deceased spouse's federal estate tax exemption. When the surviving spouse later dies, what is left in the B Trust won't be taxed as part of the surviving spouse's estate.
The surviving spouse will then be able to leave an amount equal to their own federal estate tax exemption to children or other beneficiaries. This process allows married couples to pass on two times the federal estate tax exemption free from estate tax encumbrance.
But what happens to the assets left in the A Trust? While these assets will be taxed as part of the surviving spouse's estate, payment of the tax will be deferred until after the surviving spouse passes.
Here's an example: Joe and Mary are worth $12 million, jointly. When Joe dies he has $6.25 million in his Revocable Living Trust and his estate plan includes AB Trust planning. Under these facts, $5.25 million will go into the B Trust under Mary's name and $1 million will remain in the A Trust, both for Mary's benefit. No federal estate tax will be due at the time of Joe's death. Instead, when Mary later dies the B Trust—originally holding $5.25 million—won't be taxed since it used up Joe's estate tax exemption and only what's left in the A Trust will be taxed as part of Mary's estate.
State Death Tax Gap and Use of ABC Trust Planning
Using the same facts above, what would happen if Joe and Mary lived in Oregon, which collects a separate state estate tax in addition to the federal estate tax and only offers a $1 million state exemption? Upon Joe's death $5.25 million should go into the B Trust and $1 million should go into the A Trust, but because the amount being funded into the B Trust greatly exceeds the $1 million Oregon estate tax exemption, there will be an Oregon estate tax bill of about $630,000 after Joe's death. Thus, $5.25 million will go into the B Trust, and only $370,000 will go into the A Trust.
If, however, Joe and Mary's estate plan is drafted to take advantage of the ABC Trust system, then instead Joe's estate will be divided up as follows:
- $1 million will go into the B Trust, exempt for state and federal purposes.
- $4.25 million will go into the C Trust, state QTIP only, exempt for federal purposes.
- $1 million will go into the A Trust, state and federal QTIP.
Thus, the ABC Trust plan will result in no Oregon or federal estate taxes being due at the time of Joe's death.
What Does the C Trust in ABC Trust Planning Do?
As illustrated above, the B Trust will hold the Oregon state estate tax exemption of $1 million, the C Trust will hold the difference between the Oregon estate tax exemption and federal estate tax exemption of $4.25 million, and the A Trust will hold what's left. Thus, the C Trust effectively defers the payment of both Oregon and federal estate taxes on the gap of $4.25 million between the Oregon and federal estate taxes until after the surviving spouse dies, but it still preserves the entire $5.25 million federal estate tax exemption for the next generation.
FAQs
An ABC trust, also known as a marital deduction trust, is similar to an AB trust in that it aims to maximize the estate tax exemption of both spouses. However, with an ABC trust, the surviving spouse can access the assets in the deceased spouse's trust more flexibly.
What are the disadvantages of an AB trust? ›
Disadvantages of an AB trust
The potential disadvantages include: An AB trust begins as a revocable living trust, but once the first spouse dies it becomes an irrevocable trust. No changes can be made to an irrevocable trust.
What is the difference between A and B and C trust? ›
The A Trust provides income and potential distributions to the surviving spouse, the B Trust shields assets from estate taxes for beneficiaries other than the surviving spouse, and the C Trust benefits future generations.
What is an A/B trust? ›
AB trust (also called a bypass trust or a credit shelter trust) is a tool used by well-off married individuals to legally maximize their estate tax exemptions. The strategy involves creating two separate trusts after one spouse passes.
How to avoid inheritance tax with a trust? ›
Certain types of trusts can help avoid estate taxes. An irrevocable trust transfers asset ownership from the original owner to the trust beneficiaries. Because those assets don't legally belong to the person who set up the trust, they aren't subject to estate or inheritance taxes when that person passes away.
What are the pros and cons of AB trust? ›
Pros and Cons of A-B Trust
Pros: Since the A-B trust splits into two entities when one spouse dies, the surviving spouse has limited influence over the deceased spouse's trust (bypass trust). Cons: The Internal Revenue Service (IRS) limits the surviving spouse's use of the bypass (B) trust.
What is better than an AB trust? ›
There are some substantial advantages of Credit Shelter Trust over traditional AB Trusts. The primary advantage is full estate tax exemption under federal law. The assets transferred to the credit shelter trust are exempt from the grantor and surviving spouse's creditors.
Why use an ABC trust? ›
One of the key benefits of an ABC Trust is its potential to minimize estate taxes. By dividing assets into separate trusts, the trust structure utilizes both spouses' estate tax exemptions, potentially saving a significant amount of money in federal estate taxes.
Is an AB trust a good idea? ›
An AB Trust is one of the many options available to married couples — and is something worth considering for those who live in a state without certain exemptions. AB Trusts can be a great way to guarantee your beneficiaries and provide support to your spouse after death.
What are the 3 primary types of trusts? ›
Understanding the 3 Primary Classes of Trusts
- Revocable Trusts. A revocable trust can be altered–or even terminated–at any time during the trustor's (person establishing the trust) lifetime. ...
- Irrevocable Trusts. ...
- Testamentary Trusts.
Here's an example: Joe and Mary are worth $12 million, jointly. When Joe dies he has $6.25 million in his Revocable Living Trust and his estate plan includes AB Trust planning. Under these facts, $5.25 million will go into the B Trust under Mary's name and $1 million will remain in the A Trust, both for Mary's benefit.
Are AB trusts obsolete? ›
One trust, known as an AB Trust, was once a popular type of trust for married couples that provided significant estate and death tax savings. However, recent changes in tax laws have made an AB Trust in California less advantageous from a tax perspective for most people.
Does AB trust get a step up in basis? ›
So, although the assets in the bypass trust receive a step-up in basis on the first death, the assets do not receive a second step-up in basis on the surviving spouse's death.
What is the best trust to avoid taxes? ›
One type of trust that helps protect assets is an intentionally defective grantor trust (IDGT). Any assets or funds put into an IDGT aren't taxable to the grantor (owner) for gift, estate, generation-skipping transfer tax, or trust purposes.
What is the most you can inherit without paying taxes? ›
The federal estate tax exemption is the amount excluded from estate tax when a person dies. It's increased to $13.61 million in 2024, up from $12.92 million in 2023. An estate tax is a federal or state levy on inherited assets whose value exceeds a certain dollar amount.
Do I have to pay taxes on money inherited from a trust? ›
Inheriting a trust comes with certain tax implications. The rules can be complex, but generally speaking, only the earnings of a trust are taxed, not the principal. A financial advisor can help you minimize inheritance tax by creating an estate plan for you and your family.
What are the bad things about trust funds? ›
Disadvantages of Trust Funds
Despite their many advantages, trust funds do have some potential drawbacks. One of the drawbacks is that creating a trust fund can be expensive, as it often involves hiring an attorney to draft the trust documents. Another disadvantage is that trusts can be difficult to manage.
Can AB trust be changed by surviving spouse after death? ›
The surviving spouse's trust is called the “survivor's trust”, while the deceased spouse's trust is called the “bypass trust”. The surviving spouse can make changes to their trust, but not to the bypass trust. However, starting in 2019, California has allowed surviving spouses to decant allocated A/B trusts.
Are trusts a good thing or a bad thing? ›
Benefits of trusts
Some of the ways trusts might benefit you include: Protecting and preserving your assets. Customizing and controlling how your wealth is distributed. Minimizing federal or state taxes.
