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AB Trusts

An AB TRUST is the most popular form of an ongoing trust, designed to lessen or eliminate estate taxes (an “ongoing” trust is not revocable, like a living trust). These irrevocable trusts are most effective when used by married couples with combined assets exceeding the estate tax threshold.

Here’s how an AB TRUST works:

You create an ongoing trust - either by will or within a living trust - that takes effect at your death (up until your death, you are free to amend or revoke the trust). You name your spouse as your beneficiary, who has certain rights to the trust property during his/her life. Your surviving spouse is called the “life beneficiary” of the ongoing trust.

The property you put into the trust is part of your taxable estate. However, when you use an AB TRUST, no estate tax will be due at your death - regardless of the value of your estate or the year you die (due to the unlimited spousal exemption). The main benefit of an AB TRUST comes when the life beneficiary (i.e., the surviving spouse) dies. The tax-avoidance key to an AB TRUST is that the life beneficiary never legally owns the trust property; therefore when the surviving spouse dies, the property held in the ongoing trust will not be considered part of his/her estate. This is true even if the life beneficiary had the rights to receive all income generated by the trust property, or to use the property during his/her lifetime - use of a house held in trust, for example. Because the life beneficiary never legally owns the property, it isn’t counted as part of his/her estate for estate tax purposes when the surviving spouse dies.

When the life beneficiary (i.e., surviving spouse) dies, the trust property goes to the final beneficiaries you specify in the trust document (usually your children). No estate tax is taken out of the trust property when the life beneficiary dies. By contrast, if you had left your property to the life beneficiary outright, it would have been included as part of that beneficiary’s taxable estate when he/she died.

Both couples (married or not) and individuals can create bypass/ongoing trusts, but married couples can take optimal advantage of an AB TRUST.

To understand how an ongoing trust saves on estate taxes, you must understand some basic federal estate tax rules:

Every person can leave property to anyone - tax free - up to the amount of the personal exemption approved by Congress. The current amount of the personal exemption is $1 million in 2002, but gradually increases after 2003 to $3.5 million in 2009 (quite literally, Congress has provided yet another reason to prolong life!). After 2010, however, the law is unclear, and Congress may reduce the personal exemption back to $1 million.

Married people can leave any amount tax free to a spouse who is a U.S. citizen, benefiting from what the IRS refers to as the “marital deduction.”

If you leave property worth more than the amount of your personal exemption outright to someone other than your spouse and a few years later that beneficiary dies owning property worth more than his/her own exemption, estate tax will be levied twice on your property - once when you die and again when the beneficiary dies.

With an AB TRUST - where property is left for the use of a life beneficiary and then goes to final beneficiaries - the life beneficiary never becomes the legal owner of the assets held in the ongoing, bypass trust. An appropriately drafted ongoing trust acts as an independent, legal entity, free of any person’s ownership. This is the case even if the life beneficiary (i.e., the surviving spouse) is the trustee, in charge of maintaining the trust property. Therefore, property in the trust is only subjected to estate tax when the grantor dies (i.e., the predeceased spouse), but cannot be taxed again when the life beneficiary (i.e., the surviving spouse) dies - hence the name “bypass” trust.

An example may help illustrate the point:

Jane has been married to Tarzan for over 40 years; they moved to California during their courtship and got married. Because their banana business has been good to them, they have amassed a shared estate valued at $1.6 million. Because California is a Community Property state, they each own a ½ interest in the total, meaning their individual estates equal $800,000.

Jane dies in 2024 and leaves her property outright to Tarzan. Her loving vine-swinger’s total estate is now worth $1.6 million. If he were to die a year later, in 2024, his personal exemption would be $1 million. So $600,000 would be subject to estate tax … meaning Tarzan’s federal estate tax bill would exceed a quarter-of-a-million dollars.

However, if Jane had used an AB TRUST, no estate tax would have been due on either’s death! Jane’s $800,000 is less than the exempt amount in 2024, so no tax would be due. And since Tarzan is never the legal owner of Jane’s trust property, his estate would remain at $800,000 - below the personal exemption limit, and therefore not subjected to estate tax when he dies.

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