Top 3 Reasons to Eliminate Your AB Trust
In earlier years, the estate tax exemption amount was $600,000. Anything left to children above this amount was taxed at a rate of 50%. As a result, many married couples were forced to establish an AB trust to double the estate tax exemption. Unfortunately, the AB trust has some major disadvantages.
No Step Up In BasisMost assets that are community property in California will receive a step up in basis at the death of the first spouse, which allows the surviving spouse to sell the assets without capital gains tax liability. Another step up in basis will occur for the assets that are funded in the A trust at the death of the surviving spouse, allowing the children to sell the A trust assets without capital gains tax liability. However, assets funded into a B trust will NOT receive a subsequent step up in basis at the death of the second spouse. Example: Bob and Mary Smith set up an AB Trust in 1995. They owned one home and some Apple stock. Bob dies in 1996. With the help of her attorney, after Bob died, Mary placed the the home in Trust A, and the Apple stock valued at $100,000 in Trust B. When Mary dies in 2015, the Apple stock is worth $1,000,000 ($900,000 in appreciation). Unfortunately, because the stock was in Trust B when Mary died, the Smith children will owe approximately $300,000 in capital gains tax on the sale of the stock (because of its low basis of $100,000).
No Control Over B Trust AssetsThe B trust becomes irrevocable at the death of the first spouse. This means that the surviving spouse does not have the ability to change the terms of the trust if circumstances change or if her relationship with the beneficiaries change.
Additional Tax Return Each YearThe B trust is assigned a separate taxpayer identification number once it is funded (at the death of the first spouse). This means that each year, the surviving spouse will have to file TWO separate tax returns - an individual tax return, as well as 1041 tax return for the B trust. The time and cost associated with this additional filing can be viewed as a disadvantage for the surviving spouse.
With That Said...Many couples with non-taxable estates are opting to eliminate their AB trust by creating a simpler trust that does not require the division of the estate into two separate trusts at the death of the first spouse. However, while there are certainly disadvantages associated with an AB trust, for some clients there is no better option available. This may be because the clients are in a blended family or a second marriage, and the spouses want to ensure that, if they are the first spouse to die, that their wishes are honored and that the surviving spouse cannot amend the trust to disinherit their beneficiaries. The only way to accomplish this type of planning is through the use of an AB trust (since the B trust becomes irrevocable at the first spouse's death and is not subject to amendment). Also, some couples require AB planning because of the sheer size of their estate. For clients with modest estates, under $1,000,000 for example, the current estate tax exemption of $5.43 million per person provides enough of a cushion for either spouse to be able to leave the entire estate tax-free to their beneficiaries. But for married couples with larger estates, over $5 million for example, the estate tax exemption may limit how much an individual spouse can leave tax free and the best way to double that amount is through the use of an AB trust, which allows for doubling of the estate tax exemption. Therefore, while this guide highlights that an AB trust has its disadvantages, an AB trust may still be appropriate in certain situations.