AB Trust vs. Simple Trust
For several years now the use of an “AB" trust has been in vogue, touted as necessary to maximize the estate tax exemptions of both couples. While the “AB" trust certainly provides that benefit, estate planning should involve a more nuanced understanding of the benefits and drawbacks of the “AB" trust. With all the relevant factors understood, the client will make the best decision as to which trust mechanism to use.
The “AB" trust has long been touted as the method by which a couple can minimize estate taxes. Without a trust (“AB" or otherwise), at the first spouse’s death the assets transfer to the surviving spouse. This transfer does not incur an estate tax due to the spousal exemption. But at the surviving spouse’s death, the estate tax applies (if the estate is in excess of the surviving spouse’s exemption). In the use of a simple trust, the result is essentially the same, as the surviving spouse becomes the sole owner of trust assets at the death of the first spouse. The potential problem under either scenario is that the marital assets may exceed the surviving spouse’s exemption. If the couple could utilize both of the spouse’s exemptions, the estate tax would be significantly reduced or eliminated. The “AB" trust achieves this goal, thereby increasing the amount of assets that transfer without any estate tax.
While minimizing estate tax is a worthwhile goal, there are several aspects of the “AB" trust that may be unnecessary to that end or even detract from the overall effectiveness of the estate plan. A couple should begin with an understanding of how the “AB" trust functions. The couple should also be aware of the portability provision in current tax law. Then in considering other factors specific to their situation, the couple will know which trust vehicle best suits their needs.
How an “AB" Trust Works
The “AB" trust minimizes tax liability by dividing the trust estate at the death of the first spouse into two portions, one of which remains revocable, while the other portion becomes a part of an irrevocable trust. Just to clarify, when the trust is initially set up and continuing through the death of the first spouse, the entirety of trust assets are revocable. But in an “AB" trust, after the first spouse’s death the surviving spouse must transfer a portion (usually ½) of the assets into an irrevocable trust in order to pass some assets through the first spouse’s exemption. But with an irrevocable trust, there is limited control over trust assets. Some flexibility can be built in, but the bottom line is that there must be some meaningful restriction on the surviving spouse’s access to the irrevocable trust—otherwise there is no irrevocable trust. In addition, once the irrevocable trust is created it requires the filing of its own tax return, whereas the revocable trust has no such requirement.
Many people with whom I meet with to put together an estate plan are aware of the “AB" trust’s benefit and are inclined to use it. I do not believe, however, that I have ever had a client who was aware of the new portability provision of the estate tax. In essence, this provision allows the spouses to utilize both of their exemptions without an “AB" trust. At the first spouse’s death, the surviving spouse must file an estate tax return even though no estate tax is or would be due. The return is filed for the sole purpose of electing to utilize the portability provision. This provision was new for 2011 and must be renewed in order to last beyond 2012, but certainly has the potential to provide the same benefit which was formerly achieved through the “AB" trust.
Factors to consider in deciding between an “AB" Trust and a Simple Trust
Level of wealth. The current exemptions are at $5 million per spouse. For the average couple, even one of their exemptions is far in excess of their combined wealth. While the current estate tax rules will change at the end of 2012, reverting to an exemption of $1 million per spouse if current law is not extended, the “average" couple may still fit within the lower exemption level, particularly if portability remains in effect. And while there is always uncertainty in the future of the estate tax exemption (and portability), it is highly unlikely that the political process will produce a really bad result for the “average" couple. In short, if a couple’s wealth does not exceed several million dollars, the “AB" trust may not be necessary, particularly in light of current portability provisions.
Sophistication. As noted, the “AB" trust involves the creation of an irrevocable trust at the first spouse’s death. A portion of the assets must be transferred into the irrevocable trust. With the irrevocable trust comes the filing of an additional tax return. Before that time, the trust was entirely revocable and no tax return was filed. Unfortunately, at the first spouse’s death and thereafter, the “AB" trust adds another layer of administrative time and expense. If a couple is averse to adding administrative expense to their estate plan, this factor weighs against the use of an “AB" trust.
Control. The “AB" trust takes some control from the surviving spouse over those assets transferred to the irrevocable trust. It must be so, for otherwise the trust is not irrevocable and the tax-minimizing benefit is not obtained. Some couples like this aspect of the “AB" trust because it ensures that children or grandchildren will receive at least a portion of their estate, even if the surviving spouse remarries. Other couples do not like the risk of putting the surviving spouse in a strained financial position. So this factor could weigh for or against the “AB" trust. My sense is that couples with more significant means, or with a pension that will benefit the surviving spouse, are less concerned about limiting the surviving spouse’s access to a portion of the trust estate.
These are the issues I like to discuss with clients before they decide whether to use an “AB" trust. Usually by the end of the discussion, our clients feel confident in choosing which trust mechanism best suits their needs. But with a lack of stability in the estate tax laws, an estate plan written today should really be periodically reviewed to ensure that it provides the greatest benefit with the fewest drawbacks.