An AB trust, also known as a bypass trust or credit shelter trust, is a type of trust that is utilized to circumvent limits on estate exemptions. AB trusts are particularly useful for individuals who have assets that are particularly valuable.
An AB trust is a joint trust that is owned by two spouses. When the first spouse dies, they put their assets into trust A that cannot be touched and is not taxable and trust B that passes to the surviving spouse. The surviving spouse oversees these trusts as well as the remainder of their spouses assets. Then, when the other spouse passes away, they leave both trust A and trust B, containing the remainder of their assets, to their beneficiaries. Through some legal maneuvering, the AB trust has increased the non taxable assets left to the beneficiaries.
The AB trust is designed to capitalize on the estate exemption. The estate exemption is the federally established limit for an individual seeking to pass on their assets. The estate exemption sets a maximum limit for the value of assets allowed to be passed on to a particular individual. In 2021, the lifetime estate exemption was $11,700,000.
Assets exceeding the estate tax limit will be taxed at the estate tax rate of 40%. While this does not affect the surviving spouse due to the unlimited spousal deduction, when the other spouse passes it has the potential to take a significant chunk out of the assets bequeathed to children of the spouses.
When the first spouse dies, their portion of the couple’s property, at least up to the estate exclusion, is put into a trust for the beneficiaries. This trust is irrevocable, meaning the terms cannot be adjusted or revoked, and will pass to beneficiaries other than the surviving spouse. The rest of their assets will go into a trust that the surviving spouse gets direct control over. This allows the deceased spouse’s assets to pass completely untaxed and the surviving spouse still has their own estate exemption limits when they pass.
This limited control over the Beneficiaries’ trust is also not as harsh as it initially appears. The surviving spouse can still live in the couple's house and draw income from the trust in accordance with the terms stipulated in the AB trust contract.
When constructing an AB trust, couples must be careful about the terms and wording of the trust. The Internal Revenue Service (IRS) requires specific wording for AB trusts and places strict limits on the surviving spouse’s use of the trust intended for beneficiaries. To ensure that the surviving spouse gets the most out of the trusts while still maintaining AB trust exemption status, a trusts & estates attorney reviews the final contract before it is implemented.
AB trusts may not be for everyone. Given the fees that can be involved in planning, managing, and establishing an AB trust, it can potentially be more expensive than the estate exemption. Additionally, changes in tax law have made AB trusts less viable than they once were. It is important to consult with a trusts & estates attorney or other trusted expert on whether the value of the AB trust will outweigh the cost.
If you are looking to establish an AB trust, you will need an experienced trusts & estates attorney. Due to the complex nature of the wording and limits placed on an AB trust, a trusts & estates attorney is a requirement.
By utilizing their experience, knowledge, and tax law expertise, a trusts & estates attorney can create an airtight AB trust for you in order to secure the maximum amount of assets for your beneficiaries.