A type of trust that allows a married investor to avoid estate taxes when passing assets on to heirs. The trust is structured so that upon the death of the investor, the assets specified in the trust agreement (up to a specified maximum dollar value) are transferred to the beneficiaries named in the trust (normally the couple’s children). However, a key benefit to this type of trust is that the spouse maintains rights to the trust assets and the income they generate during the remainder of his or her lifetime.
In certain circumstances, such as the need to fund healthcare expenses, the surviving spouse may even tap into the principal of the trust assets, not just their generated income. When the surviving spouse eventually dies, the assets are transferred wholly to the beneficiaries (children) without any estate taxes levied. This can amount to significant tax savings and can be very valuable, especially considering that the surviving spouse essentially maintains full use of the assets while they are in the trust anyway.
In general, all estates are subject to estate tax. However, there are certain ways to avoid paying estate taxes.
One way is to use the unlimited marital deduction. The government exempts transfers between a husband and wife from estate and gift taxes. This means that in most cases, whatever you leave to your spouse will not be taxed.
In addition to the unlimited marital deduction, the federal government gives everyone a “unified credit.” In 2010, there is no federal estate tax. In 2011, the federal estate tax is scheduled to be reinstated and the credit will exempt $1 million, subject to Congressional action.* You can use your unified credit during your lifetime to reduce or eliminate gift taxes; otherwise, it will be applied to reduce estate taxes.
Unfortunately, those who have an estate valued over the applicable exemption amount and who rely completely on the unlimited marital deduction may not benefit from their unified credit as much. Using the marital deduction at the first death merely postpones estate taxes to the death of the surviving spouse. Then, when the surviving spouse passes away, the estate tax burden may be unnecessarily large.
There are strategies you can use that may save you a substantial amount in estate taxes. One of the most widely used strategies is known as the A-B trust. This strategy can enable you and your spouse to pass on up to $2 million (in 2011) in assets — free of federal estate taxes.
By using an A-B trust, you will ensure that both spouses take advantage of the unified credit — once at the death of the first spouse, and then again at the death of the second spouse.
An A-B trust can be set up by establishing a living trust with an A-B provision. Upon the death of the first spouse, two separate trusts are created. The assets of the surviving spouse are transferred to the A trust, and an amount up to the exemption amount of the deceased spouse’s assets is transferred to the B trust. This then creates two taxable trusts, each of which is entitled to use the exemption.
The B trust is subject to estate taxes. However, because of the unified credit, no taxes will be owed. The surviving spouse maintains control over the assets of the A trust and receives income from the B trust. Then, at the death of the second spouse, only the A trust is subject to estate taxes because the B trust was taxed at the first death. After the death of the surviving spouse, the B trust can continue for the benefit of the grantors’ family, often the children. The trust assets can be divided into separate equal trusts for the benefit of the grantors’ children who will receive net income, and then at some specified age they will receive the principal.
There are many considerations involved with A-B trusts, and you’ll need the help of competent legal counsel. However, the A-B trust can be an effective way to reduce estate taxes and preserve family assets.
*As a result of the Economic Growth and Tax Relief Reconciliation Act of 2001, the federal estate tax is scheduled to be repealed in 2010. However, unless new legislation is passed, the repeal is subject to the December 31, 2010, “sunset” provision of the 2001 act. Without additional Congressional action, this means that in 2011, the federal estate tax law will revert to the law in effect prior to the 2001 tax law, and federal estate taxes will be reinstated.
This information is not intended to be tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an attorney or independent professional advisor.