Many Estate Plans consist of a strategy called the AB Trust strategy. This common Estate Planning strategy either begins with a Living Trust or a Last Will and Testament. At any rate, upon the death of the first spouse, the will either creates two trusts or the Living Trust creates another trust. There are then two trusts. Thus the AB nomenclature. The primary purpose of the AB trust is to reduce or eliminate estate taxes. It can also be used as an asset protection strategy for the heirs.
Estate Tax Overview
Both Minnesota and the Federal Government have a Death Tax, also known as the Estate Tax. When you die, if the value of all your property, life insurance proceeds, and other assets is above a certain threshold then your estate must pay this tax. As of the time of this writing in 2017, the Estate Tax threshold for the Federal Estate Tax is $5.49 million. This does adjust each year on an index that is meant to track inflation.
Minnesota’s Estate Tax is set to gradually increase to cover estates valued at over $2 million. In 2017, the threshold is $1.8 million, but it will become $2 million next year. Any estate valued above these thresholds will pay Estate Taxes. The Federal Rate is 40% while Minnesota’s rate is graduated from 10%-16%. So, if your estate is taxed at this level for both the Federal government and Minnesota you could be taxed from 50%-66% of the amount over the threshold.
The AB trust strategy is used to delay the payment of these taxes. When one spouse dies, any property that is transferred to the surviving spouse is not subject to the tax. The government allows for the surviving spouse to control it and then taxes any eligible amounts upon the death of the second spouse. Many surviving spouses will have spent a significant amount of the assets to live. This means that there is less left over to tax at the death of the second spouse.
How does it work?
The couple will make sure that their Living Trust or their Last Will and Testament put funds into either the A trust or the B trust. It is very important that this language be drafted by a qualified estate planning attorney. An error in this language could void the entire scheme. Many folks use joint accounts to avoid probate. Most of the time, joint accounts do avoid probate. However, the joint account gives the assets outright to the surviving spouse rather than to the A trust or the B trust.
If the money doesn’t make it into the trust then it can’t be a part of the strategy. Any joint accounts should have their beneficiaries changed to either the A trust or the B trust. This will make sure that the assets are in the trust and the plan works as intended.
When the first spouse dies, assets with enough value to equal the threshold for the Estate Tax ($1.8M for Minnesota and $5.49M for the Federal government) are transferred into Trust A. This is called the “Bypass Trust”, “Credit Shelter Trust”, or the “Family Trust.” This is the maximum amount that can be transferred to anyone other than the surviving spouse without paying the Estate Tax.
If there are still assets left after the threshold amounts are put into Trust A, the remaining assets move into Trust B. Trust B is called the “Marital Trust”, the “QTIP Trust“, or the “Marital Deduction Trust.” These assets pass to the trust for the benefit of the surviving spouse tax free. Taxes are delayed until the death of the surviving spouse.
What happens if your estate is less than $5.49 million dollars? Well, if your attorney files the appropriate forms with the IRS, the remaining amount can be transferred to the surviving spouse. So for instance, if Andy dies and has an estate valued at $3 million and the Estate Tax threshold is $5.49 million there is $1.49 million of unused exemption. If this is passed to the surviving spouse then the survivor may pass $6.98 million to their heirs free of the Estate Tax. So, the assets in Trust B could total up to $6.98 million upon Andy’s wife’s death and avoid the Federal Estate Tax.
These are the basics of the AB trust strategy. It can also be used to potentially handle generation skipping taxes, but that is a topic for another article. If you would like more information or have questions regarding this strategy please fill out the form below:
Any U.S. federal tax advice contained in this blog is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter that is contained in this page.