The purpose of an A-B Trust is to reduce estate taxes assessed by the IRS upon your death. An A-B Trust can only be utilized my married couples. Every individual is allowed a $1,500,000* exemption from estate taxes. Any assets exceeding the $1,500, 000 exemption are then taxed at a progressive rate ranging from 37% to 55%. However, any married person may leave at death an unlimited amount of assets to their spouse.
*(This is the exemption limit for 2004 and 2005; this amount will increase to $2,000,000 in 2006).
Assume the following facts:
Husband and Wife have assets worth $3,000,000. Husband dies, and leaves everything to Wife. This is the manner most married couples leave their property through their Will, so that the surviving spouse has use of all assets, and that at the surviving spouse's death all of the assets will be gifted to the couples' children. At Husband's death, there are no taxes due because of the Unlimited Marital Deduction. Assume the wife lives another 3 years, and the couple's assets have appreciated $500,000 in value (stocks, real estate, etc.), over that 3 year period. At Wife's death the assets now have a total value of $3,500,000.
Here is what typically happens if Husband and Wife do not have an A-B Trust:
Wife dies leaving everything to her children. Of the $3,500,000, Wife's Lifetime Exemption will protect $2,000,000, leaving the upper $1,500,000 subject to the Estate Tax . At our current tax level, Wife's estate will have to pay $825,000 in estate taxes. The children receive $2,675,000, not $3,500,000.
Here is what happens with a A-B Trust.
Same facts as above, with Husband and Wife having assets worth $3,000,000. Husband and Wife have an A-B Trust in which Husband and Wife hold all of their assets in trust for their own benefit during their lifetimes. The Trust can be revoked, modified, added to or amended at any time. Husband and Wife conduct their business and personal finances essentially as if the Trust were not in existence, except that their real estate holdings, securities and other assets are held in the Trust name.
At Husband's death, the Trust will be divided into two trusts; one trust we will call the Decedent's Trust and the other we will call the Survivor's Trust.
The Decedent's Trust will contain a certain amount of assets, determined by a formula, but not to exceed $1,500,000. Since we can place almost any type of assets into this Decedent's Trust, we will fund Decedent's Trust with the appreciating assets, such as securities, maybe a growing business, real estate, etc. The remaining $1,500,000 goes to the Survivor's Trust.
During Wife's lifetime, she does not own the assets in Decedent's Trust; however, she has access to these assets for her "education, support, health and maintenance". If the assets placed in Wife's Survivor's Trust are, or become at any time insufficient to maintain Wife in her accustomed manner of living, she has access to the funds in Decedent's Trust.
At Wife's death, the assets still owned by Decedent's Trust, and thus are not included in Wife's estate. When these assets pass to the couples' children, Husband's $1,500,000 Lifetime Exemption protects these assets from federal estate taxes.
Recall that the assets in Decedent's Trust have appreciated in value by $500,000 (remember, we funded the Decedent's Trust with the appreciating assets). Because the assets are deemed transferred into the Decedent's Trust at Husband's death, they are valued at the time of Husband's death at $2,000,000 - the $500,000 appreciation in value is not subject to estate tax.
The assets remaining in Wife's Survivor's Trust ($1,500,000 at her death) are also transferred free of tax because Wife is using her $2,000,000 Lifetime Exemption. As you can see, both Husband and Wife's Lifetime Exemption were used, and the $500,000 appreciation in value is not subject to estate tax. The entire $3,500,000 is passed free of tax, and the children have $825,000 more than if their parents had not set up an A-B Trust.
As a last note, many couples do not think that their estate will exceed
$1,500,000 at their death to justify the use of an A-B Trust. However,
inflation has effectively pushed many estates' values above this
$1,500,000 benchmark. For instance, a house worth $350,000 ten years ago
may be worth $1,000,000 now. Furthermore, a couple may have a life
insurance policy which provides for a death benefit of $500,000, which
will be included in the couple's estate. Property which may have a
nominal value to the Husband and Wife may have an entirely higher fair
market value when appraised by the IRS at its "highest and best use".
The couple may get an unexpected financial windfall, such as lottery
winnings, proceeds from a lawsuit, or inheritance. Thus, often a
couples' actual estate at the time of the second spouse's death is much
higher than first expected, and an A-B Trust is necessary to avoid or
reduce federal estate taxes.