General Overview. For the last 20 years, variations of the A/B Trust have been the cornerstone of estate tax planning for married couples. In a nutshell, the A/B Trust structure prevents all or a portion of the wealth from the first spouse to die from being included in the surviving spouse’s estate — even though she has the use of the money for the rest of her life.
Here’s how it works. (To simplify, I refer to the first spouse to die as the “husband,” and the surviving spouse as the “wife.”) The husband’s will causes his wealth to split into two shares at his death. The “B Trust” is allocated the largest amount that may pass free of federal estate tax. This was originally only $600,000. The rest of the husband’s estate is allocated to the “A Trust.” (B Trusts are frequently referred to as a “credit shelter trusts” or “bypass trusts,” and A Trusts are frequently referred to as “marital trusts” or “QTIP trusts.” For example, if the husband’s estate is $1M and the exemption is $600,000, then $600,000 is allocated to the B Trust and $400,000 is allocated to the A Trust. The executor claims the estate tax marital deduction (by making a “QTIP” election) for the amount allocated to the A Trust, but not for the B Trust. (Thus, no tax is due at the husband’s death.) The distribution standards in the A Trust and B Trust are similar: the wife receives all income along with principal as needed for her health, education, support and maintenance. When the dust settles, the wife’s estate (when she dies) includes her separate assets and the residue of the A Trust, but not any of the B Trust. Thus, the B Trust is a mechanism for giving the wife the use of $600,000 without having to include these assets in her estate at death. Many A/B wills distribute the wife’s share of the husband’s estate outright to her, rather than to the A Trust.
Potential Federal Estate Tax Savings Under Prior Law. B trusts serve a purpose if we somehow know that removing assets from the wife’s estate will reduce estate taxes at her death. For example, if the husband and wife each own $1M, and the exemption is only $600,000, a B Trust will leave the wife with $1.4M of wealth, rather than $2M, at death. When the marginal estate tax rate was 45%, this saved $270,000 of tax. But not any more.
No Federal Estate Tax Savings Under Current Law. The lifetime exemption is now $5M, and is “portable” between spouses. In other words, the unused exemption of the deceased husband may be used by the wife. For example, if each spouse owns $5M, and all of the husband’s wealth passes to the wife, she will have a $10M exemption at her death. This means that with without bothering with A/B trusts a married couple can now pass $10M to their children without any federal estate tax. Thus, portability has effectively made A/B trusts obsolete for federal estate tax purposes.
Potential Oregon and Washington Estate Tax Savings. Unfortunately, neither Oregon nor Washington has adopted portability. To make matters worse, the Oregon and Washington exemptions are only $1M and $2M, respectively. Thus, unless the exempt amount (i.e., $1M or $2M) is diverted to a B Trust, it is included in the wife’s estate. For example, if each spouse owns $1M, and a B Trust is not used, the wife’s estate will be about $2M, which will attract about $100,000 of Oregon estate tax. But if the husband’s $1M had been sheltered by a B Trust, no Oregon estate tax would be owed at the wife’s death. Thus, while a B Trust provides no federal estate tax benefit, it may save taxes for Oregon and Washington estate tax purposes.
Disadvantages to B Trusts There are several drawbacks to B Trusts, including the following:
Administrative Burden – The funds in the B Trust must be separately accounted for and separate trust income tax returns (forms 1041 and 41) must be filed every year. If the wife survives the husband by, say, 20 years, this administrative burden may outweigh the potential Oregon estate tax savings of perhaps $100,000 at the wife’s death. (Most spouses do not enjoy having to fuss with the complexity of separate accounts and separate tax returns for rest of their lives.) And it is possible that Oregon will increase its exemption sufficiently (perhaps to $2M) that a B trust will not be needed to protect the wife’s estate from death tax. A number of widows or widowers in their 50s or 60s have opted not to bother with a B Trust. The potential $100,000 tax savings — after their death — is not worth the administrative burden to them.
Lower Adjusted Basis – The assets held in a B Trust have a cost basis equal to the value at the husband’s death. Thus, any appreciation during the remainder of the wife’s life will be taxed when the assets are sold. Conversely, if the same assets pass outright to the wife and are sold after her death, there is no gain or loss. The reason is that the assets in the wife’s estate at death take on a new basis equal to fair market value at death. For example, suppose each spouse owns $1M in wealth. All of the husband’s $1M passes to a B Trust. The wife’s estate will be only $1M at death and no Oregon estate tax will be owed. But suppose the B Trust assets appreciate to $1.5M. Since the basis is only $1M, there will be capital gain of $500,000 and perhaps $120,000 of tax when the B Trust assets are sold. (This assumes a combined federal and Oregon capital gains rate of 24%.) Had the B Trust assets passed outright to the wife, the sale for $1.5M would have generated no capital gains tax. While the B Trust costs the family additional income taxes of perhaps $120,000, it saves perhaps $150,000 of Oregon estate tax, i.e., about 10% of the $1.5M in the B Trust at the wife’s death. But the net savings is only perhaps $30,000.
Current Benefits of B Trusts
Oregon and Washington Estate Tax Savings – The key benefit of a B Trust is state death tax savings.
Disinheritance Protection – A nontax benefit of a B Trust is that it prevents the wife from changing the dispositive scheme. In a second marriage situation, this means preventing the wife from disinheriting the husband’s children. Further, the wife cannot pass family wealth to a new spouse at her death. This can be valuable.
Creditor Protection - Another potential advantage is creditor protection. If the wife suffers financial reverses, the creditors cannot touch the B Trust.
Summary. A/B trusts are unnecessary for federal estate tax purposes. However, this structure may still be useful for reducing or eliminating the modest hit of Oregon or Washington estate taxes. The potential Oregon and Washington estate tax savings must be weighed against additional capital gains taxes if the B Trust assets appreciate after the husband’s death.