Wealthy married couples get a big tax break when it comes to the federal gift/estate tax. Together, they can transfer more than $10 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.
How an AB Trust Works
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 $4 million. Each leaves everything to the other. When Christine dies in 2009, her $2 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 $4 million. The estate would owe tax (at 45%) on everything over $3.5 million, the exempt amount in 2009.
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 $2 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 $2 million, and no tax would have been due.
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The "Portability" Tax Break
The portability provision (which became effective in 2011) lets the surviving spouse use any part of the total exemption -- $10.5 million for deaths in 2013, $10.68 million in 2014 -- 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 2013, 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 $5.25 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 $2.75 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.
AB Trusts: Still Useful for Some
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:
- You're not legally married. Portability is available only to couples whose marriages are recognized by the federal government. So if you and your partner are unmarried, you will not be able to use your partner's unused personal exemption. Until June 2013, the federal government (including the IRS) did not recognize valid same-sex marriages, but that changed when the U.S. Supreme Court struck down the federal Defense of Marriage Act.
- You want to make sure your children receive your property. Especially if you're in a second marriage, you might want to arrange things so that your surviving spouse can use your property after your death, but that it goes to your children after the second spouse's death. A bypass trust can accomplish that.
- You may owe state estate tax. Some states impose their own estate taxes; these taxes are in addition to the federal estate tax. Exemptions in these states are generally lower than the federal exemption, and there is no portability. So if you live in one of these states, your estate may owe state estate tax, even if it does not owe federal estate tax.
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:
- Restrictions on the surviving spouse's use of the property. The surviving spouse has only limited rights to use trust property in the irrevocable trust.
- Cost. When one spouse dies, the survivor will need to hire a lawyer or accountant to determine how to best divide the couple's assets between the irrevocable trust and the surviving spouse's revocable living trust. How the property is divided can have important tax consequences.
- Trust tax returns. The surviving spouse must get a taxpayer ID number for the irrevocable trust and file an annual trust income tax return.
- Recordkeeping. The surviving spouse must keep separate records for the irrevocable trust property.
- Uncertainty about the tax laws. Because Congress may tinker with estate tax laws again in the next few years, you may end up wanting to change or revoke a trust you create now.
To learn more about bypass trusts, avoiding probate, and many other aspects of estate planning, read Plan Your Estate, by Denis Clifford (Nolo).