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 problems with AB trusts? ›
Disadvantages of an AB trust
There may be other estate planning options for minimizing the tax consequences of transferring assets of the combined estate. The potential disadvantages include: An AB trust begins as a revocable living trust, but once the first spouse dies it becomes an irrevocable trust.
What is an ABC trust? ›
What Is An A/B/C Trust? An A/B/C Trust, often called an “A-B-C or ABC Trust,” is a kind of estate planning strategy created for married couples to reduce estate taxes and offer flexibility in asset distribution. It is also known as a “Marital Bypass Trust”. Source: A/B/C Trust (wallstreetmojo.com)
What is the difference between a trust and AB trust? ›
Key Takeaways. An A-B trust is a joint trust created by a married couple; upon one spouse's death, the trust splits into a survivor portion (the A trust) and a bypass portion (the decedent's trust, or B trust).
What are the disadvantages of a credit shelter trust? ›
One of the disadvantages of a credit shelter trust is that it does not give the surviving spouse immediate access or full control over the trust assets. Instead, the spouse can generally receive income from the trust and may be allowed to use the trust principal to pay for health, education, and maintenance as needed.
Why is AB trust obsolete? ›
For the most part, estate law has evolved enough to prevent the need for an AB trust if your intention is to prevent double taxation. AB Trusts can be challenging for couples as the deceased spouse's assets are put into an irrevocable Trust. This can limit the flexibility and freedom available to the surviving spouse.
What is an alternative to an AB trust? ›
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 is a QTIP trust and when should it be used? ›
QTIP trusts are used in estate planning and are especially helpful when beneficiaries exist from a previous marriage, but the grantor dies before a subsequent spouse does. In QTIP trust, estate tax is not assessed at the point of the first spouse's death but is determined after the second spouse has passed.
What is the difference between QTIP and AB trust? ›
In its most basic form, a QTIP trust is essentially an A/B trust arrangement that is more restrictive than a typical marital trust. In most A/B trust arrangements, the marital, or A portion of the trust, is fully accessible by the surviving spouse.
How does step up basis work on a AB trust? ›
One major advantage of A-B Trusts is that they allow for a step-up in basis for the assets passed on to beneficiaries. This means that when the assets are transferred to the beneficiaries, the cost basis is adjusted to the fair market value at the time of the transfer.
An irrevocable trust provides you with more protection. While you can't modify it, creditors can't easily make claims against it, and assets held within it can generally be passed on to beneficiaries without being subject to estate tax.
What is the major disadvantage of a trust? ›
Trusts offer amazing benefits, but they also come with potential downsides like loss of control, limited access to assets, costs, and recordkeeping difficulties.
What are the four major types of trusts? ›
Trusts can be broadly categorized into four main types: Living Trusts, Testamentary Trusts, Revocable Trusts, and Irrevocable Trusts.
What is the best trust to avoid creditors? ›
Irrevocable trust
Most trusts can be irrevocable. An irrevocable trust offers your assets the most protection from creditors and lawsuits. Assets in an irrevocable trust aren't considered personal property. This means they're not included when the IRS values your estate to determine if taxes are owed.
Which type of trust allows married couples to leave everything to each other tax free? ›
A marital trust allows the couple's heirs to avoid probate and take less of a hit from estate taxes by taking full advantage of the unlimited marital deduction—a provision that enables spouses to pass assets to each other without tax consequences.
What is the primary purpose of a credit shelter trust? ›
A Credit Shelter Trust (CST) is designed to allow affluent couples to reduce or completely avoid estate taxes when passing assets on to heirs, typically, the couple's children.
Why are irrevocable trusts bad? ›
Some downsides of an irrevocable trust include the following: You will give up much more control over your financial affairs. Additional tax returns may need to be filed for the irrevocable trust, which can add cost and complexity. Irrevocable trusts may be more difficult to create and are nearly impossible to modify.
What is a major disadvantage of an Asset Protection Trust? ›
Final answer: A major disadvantage of an Asset Protection Trust is the complexity it adds to long-term need and asset assessments, which can hinder effective financial planning for the future.
What is the primary disadvantage to creating and funding an irrevocable trust? ›
No More Control Over Assets
Naturally, the biggest downside to an irrevocable trust is the fact that you don't have any control over your assets.
