An A/B trust works like this. When the first spouse dies the B trust is funded with the first to die’s assets (one half of their community property and all of their separate property) up to the federal estate tax exemption amount which acts as a cap. Any remaining assets of the first to die along with all of the assets owned by the surviving spouse are allocated to the A Trust.
The A trust assets are included in the surviving spouse’s estate and get an additional cost basis adjustment at the surviving spouse’s death. Although the B trust avoids estate tax, assets held in this trust do not receive a basis adjustment upon the death of the surviving spouse. However, the future growth of these assets remains outside the gross estate of the surviving spouse at their death.
After the first spouse's death, Trust B and Trust C will each usually be required to file their own income tax returns. The net income of these trusts generally is payable to the survivor and passes through to the survivor for income tax purposes. The B and C trusts can have limits and restrictions on the availability of principal for the survivor. Both the A trust and the C trust assets will receive second basis adjustment when the surviving spouse dies. The B trust will not.
The new tax law, effective 2018, increased the federal estate tax exemption dramatically. The 2020 exemption is $11.58 million for individuals and $23.16 million for married couples. As a result, the overwhelming majority of people have estates that are far below the $11.58 million exemption thereby eliminating the need for federal estate tax planning with the use of A/B or A/B/C trusts. Married couples can maintain one trust until the second spouse dies without the need for any sub-trust division on the first death. This type of joint trust is called a non A/B trust and is far easier to administer.
Here are the cons of an A/B or A/B/C trust:
- It costs money and is more complicated. Significant legal and accounting fees may be required to implement the mandatory A/B or A/B/C trust split. The total date of death value of all assets must be obtained. Real estate and business interests must be appraised. Once the sub-trust division has occurred, the surviving spouse will be required to file a separate tax return for each sub-trust on a go forward basis, in addition to their own personal tax return.
- Lack of Privacy. California law requires that the beneficiaries of the B or B/C trusts are entitled to notification and a copy of the relevant portions of the trust document within 60 days from the date of the death of the first spouse. Moreover, these beneficiaries have legal rights that enable them to receive accountings of the trust assets and allow them to petition the probate court in the event that the surviving spouse does not properly fund and/or administer the B or B/C trusts. Surviving spouses often begrudge that beneficiaries have these rights.
- Irrevocability. The surviving spouse’s control over the sub-trust assets usually is limited because the B trust or the B/C trusts are irrevocable and can only be changed by the surviving spouse by seeking court intervention at great expense and uncertainty. There are plenty of valid reasons why a surviving spouse may want to amend their estate plan to account for changed circumstances of a beneficiary.
- The “Second Step up in Basis.” Due to the high estate exemptions, the tax planning focus has shifted from estate tax avoidance to capital gains tax avoidance. 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. Although the assets allocated to the B trust will receive a step-up in tax basis upon the death of the first spouse, those B trust assets will not receive another step-up in tax basis upon the death of the second spouse. Removal of the B trust will allow all of the assets to receive a second step up in basis on the second death.
- Here is an example of how the loss of the second step up in basis can hurt financially. John and Jane Davis set up an A/B Trust in 1993. They were California residents. They owned one home and some Microsoft stock. John died in 1996. After John died, Jane placed the home in Trust A, and the Microsoft stock valued at $100,000.00 (the first step-up in basis) in Trust B. At the time when Jane died in 2019, the Microsoft stock was worth $1,000,000.00 ($900,000.00 in appreciation and no second step-up in basis). Their entire estate will pass federal estate tax free because it was far below the single exemption of 11.4 million dollars. Regrettably, because the stock was in Trust B when Jane died, the Davis children will owe approximately $225,000.00 in capital gains tax (both federal and state) on the sale of the stock (because of its low basis of $100,000.00). Had there been no A/B trust or if the stock was allocated to trust A, the capital gains tax hit would have been avoided completely.
- Portability. Portability refers to the ability of a surviving spouse to claim the deceased spouse’s unused estate tax exemption (the “DSUE amount”) and “bank it” for future use. Portability can to simplify estate planning for married couples by eliminating the need for a B trust. With portability a married couple can transfer $23.16 million federal estate tax free in 2020. Prior to the law change you needed to fund the B trust in order to preserve the first to die’s exemption. Portability must be elected, it is not automatic. In order to preserve the DSUE amount the surviving spouse must file a federal estate tax return (Form 706) even though such return would not otherwise be required.
Here are the pros of an A/B or A/B/C trust:
- Bloodline Protection. The B trust or the B and C trusts are irrevocable. For example, if spouses have children from a previous relationship, and wish to limit a surviving spouse’s ability to change the trust beneficiaries, a B trust or the B and C trusts may be desirable. Although inconvenient for the surviving spouse, the restrictions and associated administration costs may well be worth the peace of mind knowing that children will receive an inheritance.
- Caregiver manipulation. You have all heard the stories about the manipulation by a caregiver later in life that results in an amendment of the estate plan that benefits the caregiver. Although there are laws in California designed to disqualify these types of gifts, an A/B or A/B/C will significantly limit the damage that can be done.
- Late in life marriages. We have seen individuals get married with the new spouse promising “don’t worry, I will take care of your kids.” An A/B or A/B/C will prevent the surviving spouse from leaving everything to the new spouse.
- Large estates. Estates in excess of the single federal estate tax exemption (currently $11.58 million) should consider retaining the B trust or the B and C trust provisions to avoid the possibility of a 40% death tax owed upon the second spouse’s death.
- Creditor protection. Because the B and C trusts are irrevocable, they provide creditor protection. This can be significant for individuals in high risk professions such as doctors or general contractors. A surviving spouse can be sued and loose all of the A trust assets to a creditor. But the B and C trust assets are protected and will be available for the surviving spouse and ultimately the children. Additionally, “spend thrift” provisions can be added to the B and C trusts to protect the trust assets from the creditors of the children.
You must weigh the pros and cons of using A/B or A/B/C trust planning and make the best choice for your personal circumstances. Many of our clients are converting their trust to a non-AB trust by way of a trust amendment. The recommended approach for most families whose assets are far below $11.58 million exemption is to create a non-AB trust, or amend their current trust to a non-AB format.
We are encouraging our clients and potential clients to contact us should they wish to discuss these important issues further.
If you have any questions or would like more information, please don't hesitate to call (877-585-1558), email us or register to one of our free webinars.
By Christopher Botti