Wednesday, September 29, 2010

What is an AB Trust?

Estate planning tools are like pharmaceuticals. For every brand name there is a generic version that does the same job. In estate planning, usually this concept is reserved for the more complex asset protection trusts, but I've seen some attorneys creating their own unique name for the most traditional of estate planning tools, the revocable trust used as an AB trust. There's nothing wrong with the practice per se, but it can be confusing when you're trying to engage in your own estate planning and hear so many different titles. Attorneys do it to differentiate their product from the very beginning. A good attorney needs only to provide superior service to reach the same goals, but it doesn't hurt to also be able to push a product that it appears no one else has because of the unique name they use.

In reality, when it comes to simple estate planning, every attorney will use a revocable trust as an AB trust. A revocable trust is simply an ownership entity that holds property for a beneficiary to receive later. Most often, it's used by a family or individual to hold property to be disbursed at their death. They do so to avoid forcing their families to use the probate court to distribute their probate property, among many other reasons. So what is an AB trust?

An AB trust is the most commonly used type of revocable trust for estate planning. When your neighbor tells you he and his wife completed their wills and family trust, the attorney most likely drafted an AB trust. An AB trust is called that because it actually has two trusts within it. However, neither comes in to existence until the first spouse passes away. The occurs to ensure your family pays as little estate tax as possible.

The estate tax taxes an individual's property at a high rate upon their death. This is also known as the death tax. Fortunately, every American citizen has an estate tax exemption amount, meaning that no tax will be levied against any of their property up to a certain aggregate amount. In 2010 there is no estate tax, but last year the estate tax exemption amount was $3.5 million. So every dollar an individual had above $3.5M was taxed at 55%.

Couples can use both of their individual exemptions together, but only if planning measures are taken in advance.

When the first spouse dies, the family trust splits in to two parts. The A trust (also known as the Marital or QTIP trust) and the B trust (the Bypass or Family trust). An amount equal to the estate tax exemption amount will pour in to the B trust. This happens so that the family can use the deceased spouse's estate tax exemption. For example, Jack and Jill have $8M together. Jack passes away in 2009. Jill will make sure that $3.5M worth of the couple's property will pour into the B trust. That property can appreciate in value, but will not be subject to the estate tax upon Jill's death. The other $4.5M will fund the A trust thanks to a law that allows all of a couple's property to pass to the surviving spouse without any immediate tax consequence. This is known as the marital deduction and is why the A trust is call the marital trust. Upon Jill's death, only the amount that exceeds the estate tax exemption will be subject to the estate tax.

What's the alternative? Upon Jack's death, Jill uses that same marital deduction law to acquire all of the couple's property as her own property. Upon Jill's death, she only has her own estate tax exemption to avoid estate taxes. We can't predict what the estate tax exemption and rate will be in the future so let's use 2009's numbers. Using the AB trust, $1M will be subject to the estate tax. At a 55% rate, the tax will be $550,000. Without the AB trust, $4.5M will be taxed, resulting in $2,475,000, a difference of almost $1,925,000!

Most readers will say, all of that is irrelevant to me because I will never own $3.5M in assets, let alone $7M. I have two responses to that. First, don't underestimate your lifetime earnings! While these dollar values may seem out of reach in your 30s and 40s, investments can grow quickly, your home will (eventually) appreciate and you may benefit from an inheritance yourself. Additionally, while a life insurance death benefit is income tax free, it is added in to your estate for estate tax calculation purposes if your spouse is the beneficiary.

Second, the 2009 estate tax threshold was very high. As the government's need for income increases, the estate tax exemption amount could fall considerably. In fact, if Congress doesn't act, the exemption will drop in 2011 to $1M.

AB language is just one reason to create a revocable family trust. There are many more. Give me a call and we'll discuss what makes sense for you and your family.

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