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AB Trusts: The Tax-Saver

An AB trust is a trust created by married couples to maximize their federal estate tax exemptions. A lot of people believe that AB trusts only benefit those with large estates. The truth is anyone who may owe estate tax can benefit from an AB trust.

How the AB trust system works

Normally, when one spouse dies passing on his/her assets in a last will and testament, the estate will be taxed heavily before the beneficiaries receive it. To avoid this steep estate tax, spouses can set up an AB trust, where each spouse leaves their property to an irrevocable trust. When the first spouse dies, the beneficiaries (usually the couple's children) named in the trust receive that spouse's property. However, this irrevocable trust is to be used for the benefit of the surviving spouse, who does not technically own the property. There is a crucial condition that the property can be used by the surviving spouse and that the surviving spouse may even spend principal in certain instances. Once the surviving spouse dies, all the property rights and benefits of the irrevocable trust pass to the surviving beneficiaries of the trust. Because the surviving spouse does not own the property, it is not subject to estate tax. Setting up an AB trust this way keeps the portion of the surviving spouse's estate that is taxable half of what it would be without an AB trust.

Imagine a joint trust with $4,000,000 in assets. Husband dies leaving all of the trust property to Wife. Because transfers between spouses are not subject to estate tax, Wife will get the full $4,000,000, tax free. When wife dies, leaving all of the property to Child, only half of the joint trust assets are exempt from tax. So, Child would be very steeply taxed on $2,000,000. Child therefore receives a substantially smaller amount than the $4,000,000.

Now imagine that Husband and Wife created an AB trust of $4,000,000 before Husband died. When Husband dies, the trust is divided so that Husband's share, $2,000,000, is put into Trust A (now irrevocable), and Wife's share, $2,000,000, is put into Trust B. Wife cannot sell any of the property in Trust A, but she can use it and pocket all of the income and interest that it generates. She can also use, sell, or convey any of her own assets in Trust B. When Wife dies, the trust property is distributed to Child. Because Husband's share was not immediately transferred to Wife, rather it was transferred to the AB trust, his $2,000,000 remains tax exempt. So, this entire $2,000,000 passes to Child tax free. Wife is also eligible for her $2,000,000 exemption, and so it can also pass to Child tax free. So, Child receives $4,000,000 tax free, which is substantially more than Child would have received through a joint trust.

The surviving spouse does have rights over the assets

As mentioned, the AB trust is left with the condition that it is to benefit the surviving spouse. This gives the surviving spouse some power over the assets in the AB trust, though this power is limited. The rights she has depend on the provisions of the trust itself, and this language in the trust itself is governed by the limits of the IRS. If the trust grants the surviving spouse more power than the IRS allows, she illegally owns the property of the trust.

The surviving spouse's rights and benefits include receiving all income from the trust property, including interest; using the property; and spending to benefit his or her health, support and maintenance, standard of living, and education. The surviving spouse maintains these rights until her death, at which time all of the property is distributed to the beneficiaries of the original trust, and all of the surviving spouse's property is distributed to his or her beneficiaries.

There are some disadvantages of establishing an AB trust

The AB trust is irrevocable. Once one spouse dies, there cannot be any changes made to the trust. This can create some issues and has even caused friction between the surviving spouse and the named beneficiaries of the trust. As mentioned, the surviving spouse's rights to use the property are limited. Where at one time this used to be the property he or she shared with his or her spouse, to do with as they pleased, this property is now restricted to certain uses and rights.

Settling and distributing property in an AB trust can be expensive. It usually calls for a lawyer and accountant to decide the best way to distribute the couple's assets between the irrevocable trust and the surviving spouse's living trust. Anytime you distribute property, there are tax consequences. A trained accountant or lawyer is needed to help you understand these tax consequences so that you can figure out how to best distribute the property. Furthermore, these tax laws are always changing. You'll need to keep current, or hire a professional to keep you current, on these changes and what they mean for you and your trust. These changes may even encourage you to change or even revoke your trust.

There is a lot of paperwork and bookkeeping required in an AB trust. The surviving spouse needs a tax ID number for the irrevocable trust and must file annual income tax returns on the trust. He or she must also keep records of all the AB trust property.

An AB trust can be very beneficial in saving money. Without one, you could find yourself paying quite a large chunk of estate tax. Compare these advantages to the disadvantages to make sure that an AB trust is what is right for you and your family.

How to tell if an AB trust is right for you

AB trusts are not right for everyone. An AB trust is best suited for those married couples who are both over the age of 60 and do not have children from previous marriages. It would be burdensome on a young surviving spouse to have his or her property restricted for the rest of her life, when she once shared this marital property with such free reign. Often times when there are children from previous marriages conflicts arise between the surviving spouse and the deceased spouse's children about who should share in the assets. If you think an AB trust might be for you or you have more questions, you should consult an attorney who can advise you based on your specific circumstances and your specific needs.

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