What is an AB Trust (also known as A-B, Trust, A/B Trust, or Bypass Trust)? AB trust explained. Should an AB Trust be part of an Estate Plan? Does the increase in the federal estate tax exemption and new portability deadlines make AB trusts obsolete? What should I do if I have an AB Trust?
By James L. Cunningham Jr., Esq.
(blog updated 08/07/2023)
Navigating estate planning can be daunting. Differing personal circumstances may demand very different kinds of trusts, and it can be hard to know which one is right for YOU.
One trust, known as an AB Trust, was once a popular type of trust for married couples that provided significant estate and death tax savings. However, recent changes in tax laws have made an AB Trust in California less advantageous from a tax perspective for most people.
So, what is the AB Trust definition? What are some of the main advantages and disadvantages of AB Trusts? And are AB Trusts obsolete?
In this blog, we will dive into the good, the bad, and the ugly of AB Trusts, exploring their history, benefits, drawbacks, and alternatives, drawing on my insights as a certified specialist in estate planning, trust, and probate law with decades of experience. CunninghamLegal specializes in complex estate and tax planning. Set up a call with us to learn more.
What Are AB Trusts and How Do They Work? AB Trusts Explained
An AB Trust (sometimes called A/B or A-B) is a type of revocable living trust. This means it can be changed, amended, or revoked during the lifetime of the people who create the trust: the Settlor, Grantor, Trustor, or Trustmaker. When the first spouse dies, the trust is divided into two parts: the A Trust and the B Trust. The A Trust, also known as the Survivor’s Trust, holds assets for the benefit of the Surviving Spouse. The B Trust, also known as the Decedent’s Trust, Credit Shelter Trust, Exemption Trust, or Bypass Trust, holds the deceased spouse’s half of the trust property typically for the benefit of the Surviving Spouse.
A primary purpose of the B Trust is to save on federal estate taxes upon the death of the surviving spouse, i.e., the second spouse to die. However, the increased estate tax exemptions have made this benefit less relevant for most Californians. The law changed in 2011 and again in 2017 in several big ways, making AB Trusts less beneficial and creating a Capital Gains Tax liability for many people.
What Is the History of AB Trusts? Why Were AB Trusts Created?
AB Trusts became popular due to the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which was enacted during President Ronald Reagan’s administration. TEFRA closed tax loopholes—while at the same time reducing overall tax rates.
Before TEFRA, individuals could only leave $60,000 without paying Federal Estate Tax. After TEFRA, that amount soared to $600,000. This translated into a significant tax savings at the time, but still a very low threshold.
AB Trusts were initially designed as a strategy for couples to “double up” on their $600,000 “exemptions” so that couples could pass $1,200,000 in assets free of any Federal Estate Tax which as the time taxes wealth at up to 55%. This represented a potential tax savings of $330,000 per couple.
However, changes in tax laws since 2011 and 2017 have made AB Trusts less advantageous for most people. This is because US Citizens and residents can now leave $12.92M without incurring a Federal Estate Tax—and will be able to leave a projected $7M per person starting in 2026, when the current laws from 2017 expire on December 31, 2025.
For most Californians, AB Trusts have lost their positive tax attributes and can now result in negative Capital Gains Tax consequences which we discuss below.
The Good: What Are the Advantages of AB Trusts?
While AB Trusts have become less popular in recent years due to changes in tax laws, they still offer some benefits:
- Creditor Protection: Assets placed in the B Trust can have varying degrees of protection from the Surviving Spouse’s creditors. This can provide surviving spouses and beneficiaries with financial security and peace of mind.
- Control from the Grave: The deceased spouse gives instructions concerning the assets in the B Trust, and the trustee of the B Trust can ensure the deceased spouse’s wishes outlined in the trust are carried out. This can be particularly important when there are concerns about how assets will be managed or distributed.
- Multi-Generational Planning and Generation-Skipping Transfer Tax: AB Trusts can be beneficial for multi-generational estate planning, as they can help take advantage of and preserve certain tax benefits when it comes to minimizing or avoiding generation-skipping transfer taxes. That means AB Trust estate planning can be a valuable tool for families looking to preserve wealth across multiple generations.
The Generation-Skipping Transfer Tax (GSTT) is a federal tax imposed on wealth transfers made to beneficiaries who are two or more generations younger than the donor. This typically includes transfers to grandchildren or more distant descendants. The GSTT is designed to prevent families from avoiding estate and gift taxes by skipping generations when transferring wealth.
Transfers subject to the GSTT are taxed twice—once at the level of the donor’s estate or gift, and once as a generation-skipping transfer. The current GSTT rate is equal to the highest Federal Estate Tax rate, which at this time of writing in 2023 is 40%. In 2016 it is slated to increase to 45%.
There is, however, a GSTT exemption that allows a certain amount of wealth to be transferred without incurring the tax. This exemption is adjusted periodically for inflation and is currently set at $12.92M per individual for 2023. Any transfers above the exemption amount are subject to the generation-skipping transfer tax. In 2026, it is scheduled to go down to about $7M.
An AB Trust can be beneficial in minimizing or avoiding the GSTT for families looking to preserve wealth across generations. By properly structuring an AB Trust, families can allocate the GSTT exemption to trusts that will benefit grandchildren or more remote descendants, thereby avoiding or minimizing the tax impact of these transfers.
The Bad & the Ugly: What Are the Disadvantages of AB Trusts?
Despite their advantages, AB Trusts have disadvantages. Some notable drawbacks include:
- With “Portability,” the Focus has Shifted: Portability is a feature of U.S. federal estate tax law that allows a surviving spouse to effectively inherit the unused portion of the deceased spouse’s estate tax exemption ($12.92M in 2023). This can help reduce or eliminate estate taxes for the surviving spouse by effectively doubling the exemption amount available to the couple. Portability makes AB Trusts significantly less necessary for most people, and alternative trust options may be more tax-efficient. The focus has shifted instead to minimizing Income Tax and Capital Gains Tax. The AB Trust does a poor job of addressing Capital Gains Taxes.
- Negative Capital Gains Tax Consequences: The structure of AB Trusts can lead to negative capital gains tax consequences for ultimate beneficiaries following the death of the surviving spouse. This is particularly relevant for Californians, who face a maximum federal capital gains tax rate of 20% (and 25% for recapture of depreciation), a state income tax rate of up to 13.3%, and a 3.8% net investment income tax, totaling a potential tax bill of 37.1%.
Let’s use an example: a Rental Property was originally purchased for $1M by Hal and Wanda. Hal dies, and the Rental Property flows into the B Trust following Hal’s death. In the years after Hal’s death but before Wanda’s passing, it has appreciated to $2M. At Wanda’s death, the Rental Property DOES NOT receive a “step-up” in basis and is subject to $543,400 in tax between federal, state, income, and capital gains taxes. A successful termination or modification of the B Trust could result in a savings to the family of $543,400…or more!
In this context, it is crucial to carefully consider the trade-offs between federal estate tax savings and capital gains tax consequences when deciding whether an AB Trust is the right choice.
How Do Death Taxes and Future Estate Tax Exemptions Affect AB Trusts in California?
While the Federal Estate Tax Exemption has significantly increased over the years, it’s important to remember that state death taxes may still apply. In California, there is currently no State death tax, but other states may have estate or inheritance taxes that could impact your overall tax liability.
Some professionals characterize the loss of Proposition 13 property tax protections as a form of inheritance tax. When a parent dies and the children inherit the property it is typically reassessed and the property taxes can increase significantly: thus, a death tax of sorts.
Additionally, the current Federal Estate Tax laws are set to sunset at the end of 2025, meaning that the exemption amounts will likely decrease. The federal estate tax exemption is due to be reduced by 50% in 2026 to around $7M per person ($5M in 2011 dollars plus inflation). The federal tax rate is also planned to increase from 40% to 45% on January 1, 2026.
Staying informed about changes in tax laws and working with a knowledgeable estate planning team like the one at CunninghamLegal, who can help you with your estate plan to optimize it for tax efficiency. Set up a call with us to learn more.
How to Avoid Overpaying Taxes with Savvy Estate Planning on AB Trusts
If you’re concerned about the potential drawbacks of an AB Living Trust, it’s essential to pursue a full consultation with an experienced estate planning attorney to discuss your options.
A couple with an outdated AB Trust may choose to restate their trust, amending it to better suit their current needs and tax circumstances. This process involves creating a new trust document that incorporates the desired changes.
It’s crucial to work with a savvy estate planning attorney and a well-rounded team of professionals to avoid overpaying taxes and to optimize your overall estate plan. This is particularly important in light of potential changes to tax laws, inflation, and the future of estate tax exemptions.
There are a number of laws you must continue to follow to avoid unexpected issues and find new ways to set up a trust for tax purposes. An experienced attorney can provide you with resources and specific situation-based insights to ensure your assets and money in the trust will be protected from over-taxation.
What Do We Do as California Estate and Tax Planning Attorney Specialists?
The lawyers and staff at CunninghamLegal help people plan for some of the most critical times in their lives and then guide them through when those times come. We have offices throughout California with expert estate planning, tax planning, and real estate transaction attorneys. We invite you to contact us for help and advice. We offer in-person, phone, and virtual appointments. Just call (866) 988-3956 or book an appointment online.
A key goal of our practice is client education. We invite you to keep updated with tax laws and regulations, as they often change. Subscribe to our YouTube channel and newsletter.
We look forward to working with you!
Best, Jim
James Cunningham Jr., Esq.
Founder, CunninghamLegal
At Cunningham Legal, we guide savvy, caring families in the protection and transfer of multi-generational wealth.
