AB trust planning has long been the traditional approach to estate planning for married couples. With the recent increase in the federal estate tax exemption, not to mention the introduction of portability, which allows a surviving spouse to use the deceased spouse’s unused applicable exclusion amount, your clients may be questioning their existing strategy. Is there a simpler way to minimize estate taxes, or is AB trust planning still effective? Let’s take a closer look at available options, along with their pros and cons.
Traditional Estate Tax Planning
With an AB trust design (aka “bypass” planning), when the first spouse dies, the bypass trust is funded with an amount equal to the applicable exclusion amount in order to minimize federal and state estate taxes. Any remaining marital assets are transferred to the surviving spouse outright or held in trust for his or her benefit (see Figure 1).
Assets owned by the deceased spouse receive a basis adjustment at his or her death. The marital assets that are included in the surviving spouse’s estate get an additional basis adjustment at the surviving spouse’s death. Although the bypass trust avoids estate tax, assets held in this trust do not receive a basis adjustment when the second spouse dies. The future growth of these assets remains outside the gross estate at the death of the second spouse, however.
Many of your clients likely have an AB trust design in place. These trusts often contain inflexible funding formulas that force substantial assets owned by the deceased spouse into the bypass trust to minimize taxes. With the federal estate tax exemption amount steadily increasing—now at $5.49 million—a surviving spouse could feel “disinherited” and left with less control over the couple’s assets at the first spouse’s death. A surviving spouse might decide to scrap this funding plan entirely (to his or her potential detriment) and more toward a more simplified approach.
More Simplified Trust Planning Through Portability
The current federal portability provision has given rise to a more simplified approach to trust planning. The portability provision allows the first spouse to leave all of his or her assets to the surviving spouse. For example, for federal estate tax purposes, at today’s $5.49 million exemption amount, a couple can protect $10.98 million without using AB trust planning. Often, clients who implement this simplified approach work with a joint trust established by both spouses rather than two separate trusts. What’s the advantage? The entirety of the couple’s assets—those left by the deceased spouse and those of the surviving spouse—will receive a basis adjustment at the surviving spouse’s death.
Many attorneys draft more flexibility into the trust by using a disclaimer provision for federal tax planning. With a disclaimer trust, when the first spouse dies, the surviving spouse receives the trust assets. The surviving spouse then has the opportunity to make a disclaimer election, whereby the trust directs the disclaimed assets to the bypass trust. This allows the surviving spouse to use all or a portion of the deceased spouse’s estate tax applicable exclusion amount. Further, it may bring clients peace of mind, as they don’t have to commit to automatically funding the bypass trust.
Here, be sure the client understands the planning responsibility left to the surviving spouse.
- Will the surviving spouse have to examine the tax picture and execute a disclaimer to minimize taxes?
- Does the surviving spouse understand the nature of the election?
If not properly educated about the benefits of this planning option, the surviving spouse might end up believing that he or she has been disinherited by executing a disclaimer and allowing assets to be placed in the bypass trust.
The Role of State Estate Tax Planning
Keep in mind that some states haven’t adopted portability, and many states have implemented estate tax legislation with significantly lower exemption amounts. As a result, the traditional AB trust strategy remains a valid solution for preserving the availability of the state tax exemption between spouses. Let’s look at an example to help illustrate this point.