Wealthy married couples get a big tax break when it comes to the federal gift/estate tax. Together, they can transfer nearly $11 million without owing federal gift tax or estate tax. This ability to combine each spouse's individual estate tax exemption is called (by tax lawyers, anyway) "portability." For many couples, it eliminates the need to create an AB trust, or bypass trust, to avoid estate tax.
Under the old tax laws, each spouse had an estate tax exemption, but typically, the first spouse to die didn't use his or her exemption. That's because most spouses left everything to the survivor, and bequests to a surviving spouse aren't subject to estate tax. (This rule is called the marital exemption.) But the surviving spouse then owned all the couple's assets. If those assets were over the individual estate tax exemption amount, estate tax would be owed when the second spouse died.
Christine and her husband Terry have combined assets worth $8 million. Each leaves everything to the other. When Christine dies in 2016, her $4 million goes to Terry. No estate tax is due because of the marital exemption. When Terry dies later that year, his estate is the whole $8 million. The estate would owe tax (at 40%) on everything over $5.45 million, the exempt amount in 2016.
With an AB trust, instead of leaving their property to each other, both spouses leave their property to an irrevocable trust. The survivor receives any income from trust property and under some circumstances has access to the principal. Typically, the couple's children inherit the property after the second spouse dies. Because the surviving spouse never technically owns the assets in the trust, those assets wouldn't become part of the surviving spouse's estate and aren't subject to tax at the second spouse's death.
If Christine and Terry had used an AB trust, when Christine died, her $4 million would have gone into an irrevocable trust. It would have been subject to estate tax at that time, but because her estate was worth less than the federal estate tax exemption, no tax would have been due. For the rest of his life, Terry would have had the right to use the trust property, though he didn't own it. When Terry died, his estate would have just contained his $4 million, and no tax would have been due.
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The portability provision (which became effective in 2011) lets the surviving spouse use any part of the total exemption -- $10.98 million for deaths in 2017 -- that isn't used by the first spouse to die. So for most couples, there's no need for an AB trust.
Christine and Terry have a combined estate worth $8 million. Each leaves everything to the other. When Christine dies in 2016, her $4 million goes directly to Terry, who then has an estate of $8 million. No estate tax is due because of the marital exemption. When Terry dies later that year, his estate can use his $5.45 million personal exemption plus Christine's unused personal exemption. Together those exemptions cover Terry's entire $8 million estate and no estate tax will be due. Without portability, Terry's estate would owe tax on $2.55 million.
The survivor doesn't automatically have the right to use the deceased spouse's leftover exemption; the surviving spouse must file an estate tax return when the first spouse dies, even though no tax is owed.
The large personal exemption and portability mean that most couples won't need an AB trust. However, an AB trust may still be useful if:
If you are interested in an AB trust, talk to an experienced estate planning lawyer. These trusts have big benefits, but they have drawbacks, too:
To learn more about bypass trusts, avoiding probate, and many other aspects of estate planning, read Plan Your Estate, by Denis Clifford (Nolo).