I helped John and Wanda set up an A-B Trust. John died first. It was a long, close marriage, and Wanda’s grief was so intense that she was really unable to do anything. After a number of months, she finally felt able to make some decisions. The A-B Trust that I set up for her was funded by the “disclaimer method.” (More on this later.)

Wanda officially “disclaimed” $700,000. That means that she signed a written document that complied with all the legal requirements of a “Qualified Disclaimer.” On this Qualified Disclaimer she listed her home and stock that together had a value of $700,000. We chose assets that we thought would appreciate in value but not generate much income. (More on this later.)

The provisions of John and Wanda’s trust directed that any assets disclaimed by the surviving spouse (Wanda) would automatically be transferred to the B trust, thus removing it from her control. As long as the B trust is not within the control of the surviving spouse, it will not be considered part of her estate for estate tax purposes.

When Wanda died a few years later, her estate was worth $800,000. Since that amount was less than $1 million, her two sons and her daughter paid no estate taxes on that amount. In addition, they received the $700,000 without having to pay any tax.

Without the A-B Trust, Wanda’s estate would have been valued at $1.5 million. The first $1 million would have been exempt. (Fifteen other states, including Minnesota, also have exemptions ranging from $1 million to $5 million. Minnesota’s exemption, for example, is $2.7 million for 2019.) But $500,000 would have been subject to Oregon’s estate tax of 10% or $50,000. So you can see how just a little bit of planning can save many thousands of dollars.

It’s easy to see the bottom line from this example: Use an A-B Trust and save estate taxes. But most people without a graduate degree in tax are very confused by the language of the A-B Trust.

In particular, specific provisions seem confusing and counter-intuitive.

But specific provisions cannot be understood without knowing what the overall A-B trust plan is designed to accomplish and how it works, which we will discuss below. (You will not get a sentence by sentence explanation in this post, but if you’re interested in that level of detail, please email me or give me a call, and I’d be happy to walk you through each sentence.)
 

WHAT IS THE PURPOSE OF AN A-B TRUST?

The purpose of an A-B Trust Plan is to decrease your estate tax.

 
 
HOW DOES AN A-B TRUST PLAN DECREASE YOUR ESTATE TAX?

To understand how an A-B Trust Plan works, there a few concepts that you need to understand.

1. The first is the estate tax “exemption.”

What is an estate tax “exemption”? This is the amount of your wealth that is notsubject to the estate tax at your death. For example, if you live in Oregon, where the first $1 million of your estate is “exempt” and you die with an estate worth $1.5 million, then you pay estate taxes on $500,000 but nothing on the first $1 million.

Thirty-four states, since 2005, have no estate tax at all. But 16 states do, with the exemption amounts ranging from $1 million to $5 million, with Minnesota coming just in the middle with an exemption amount in 2019 of $2.7 million.

In addition, there is a federal estate tax. Over the past 50 years, the exemption amount has increased from $60,000 to $11.4 million where it is currently and affects less than 0.1% of the population.

1. The second thing to understand is the “unlimited marital deduction,” which simply means that a spouse can leave an unlimited amount of assets to his or her spouse without any gift or estate tax being due (as long as there are no “strings attached”). Although this sounds good, it’s really a trap: the unlimited marital deduction doesn’t eliminate the tax: it just defers the tax until the surviving spouse dies.

Not only is the tax just deferred, the exemption amount for the first spouse to die is wasted and significant taxes would have to be paid that could be avoided through good A-B trust planning.

In an A-B trust plan, the B trust (also called the “credit shelter” trust or the “bypass” trust) is funded at the death of the first spouse to die with an amount equal to or less than the amount of the current exemption.

Although the surviving spouse has some access to the assets in the trust, the significant restrictions on that asset disqualify it for the marital deduction, making it subject to the estate tax. But because it is subject to the estate tax at the death of the first spouse, it is not again subject to the estate tax when the surviving spouse dies and the assets pass to the ultimate beneficiaries without being taxed.

As a result, the entire value of the B trust passes to the ultimate beneficiaries (the children or grandchildren, for example) estate tax free, even if the value of the trust’s assets have significantly appreciated in value.

Here’s the catch:

In order for the A-B trust plan to save taxes, the surviving spouse has to follow certain rules. Specifically, he or she has three — but only three ways — to get money from the B trust:

1. Income. The surviving spouse can always get all of the income from the trust, like interest income or rental income;

2. Principal to maintain standard of living. The surviving spouse can also obtain sufficient principal to maintain the standard of living he or she enjoyed while the other spouse was alive; and,

3. 5%/5,000 Rule. The surviving spouse can also take out $5,000.00 or 5% of the principal (whichever is greater) every year without having to give a reason.

A Living Trust containing an A-B trust plan thus allows the surviving spouse to take advantage of the unlimited marital deduction provided by the IRS and also pass double the exemption amount to their children or designated beneficiaries for a tax savings of up to hundreds of thousands of dollars.

FUNDING WITH THE DISCLAIMER METHOD

The disclaimer method is one of three main methods to fund the B trust. It is the most flexible and many experts consider it the most desirable for estates with assets less than twice the exemption amount.

Here’s how it works: Within nine months of the death of the first spouse, the surviving spouse determines the total value of their estate. If there is any amount over the state or federal exemption amount, he or she “disclaims” an amount necessary to reduce or eliminate the estate or inheritance tax on his or her ultimate death.

In some cases, this can be a difficult decision. It is best to consult a financial advisor and an experienced estate planning attorney at this time. You should expect to pay each of these advisors for two to three hours of work at their regular hourly fee. However, if your estate is significantly over the exemption amount, you will probably save in the scores or even hundreds of thousands of dollars by making sure that this decision is made correctly.