For most couples who do not have trusts, if one dies, everything goes to the spouse. If a married couple will have more than $5.49 million of assets (including life insurance death benefits), then having everything go to the spouse could cause an estate tax problem. In 2021, a person can die with up to $11,700,000 without paying any federal estate tax, but after 2025, the federal estate tax exemption is scheduled to go back to $5,000,000 adjusted for inflation. Hawaii State only allows an estate tax exemption of $5,490,000 permanently. (Also keep in mind that President-elect Biden has proposed a plan to reduce the estate tax exemption to $3.5 million per person, so we need to monitor these changes over time.)
For example, suppose a husband and wife together own assets worth $8,000,000. When the husband dies, everything goes to the wife. The wife then owns $8,000,000 of assets. After 2026, $5,490,000 of assets will be exempt from the estate tax (it might be a slightly higher exemption for federal estate tax). When the wife dies, there will be both a State and Federal estate tax on the extra $2,500,000 or so of assets. The tax would be over $1 million! (We can’t calculate exactly what it would be because we don’t know what the inflation amount will be for the next few years).
The problem with having everything go to your spouse when you die is that your ~$5.5 million exemption could be wasted. The purpose of A-B Trusts is to make it possible for both husband and wife to use their exemptions, doubling the amount with which they can die tax free.
With A-B Trusts, the husband and wife usually separate their assets so that each owns about half of the assets. When one of them dies, that person’s trust automatically creates 2 new “sub trusts.” A “sub trust” is a trust created by another trust. One of the sub trusts is called the “A” trust and the other is called the “B” trust. When one dies, the maximum amount that can go tax free (up to $5.49 million this year) will go into the “B” trust. The rest of the assets of the person who dies will go into the “A” trust. The trust can be written so that the surviving spouse can control both the A trust and B trust as trustee. The surviving spouse is usually free to use all of the money in the A trust. She can also get all of the income from the B trust and any amount of principal necessary for her health, education, maintenance or support. Yet when she dies, the assets in the B trust are not taxed in her estate, because she doesn’t own those assets.
If the husband and wife with $8 million of assets had A-B trusts, this is how it would work. They would separate their assets so that each owns about $4,000,000 of assets. If husband dies this year, his trust would create a sub trust called the “B” trust. (No “A” trust would be created because he has less than $5.49 million in assets.) All of his $4,000,000 of assets would go into the B trust. As trustee of her husband’s B trust, wife can control the investing of her husband’s assets. She can at any time take out of her husband’s B trust all of the income earned, such as interest and stock dividends, and any principal (any amount of the $4,000,000), as needed for her health, education or support. Yet, when she dies after 2025, she is not taxed on the $4,000,000 in her husband’s B trust, because she does not own it. The $4,000,000 in her own trust is not taxed, because it is less than the $5.49 million exemption. Therefore, the entire $8 million goes to the children tax free. They save over $1,000,000 in taxes by having A-B trusts.
It is sometimes difficult to tell whether your trust is an A-B trust or not, because only a few trusts actually use the terms “A trust” and “B trust.” The “A” trust is often called the “marital trust,” “spouse’ s trust” or ”Q-TIP trust.” The B trust is called the “B trust,” “credit shelter trust,” “exemption equivalent trust,” “by-pass trust,” “family trust,” “residuary trust,” or “children’s trust.” There are at least 7 different names that are used for the “B” trust! But be careful, because sometimes the terms “family trust,” “residuary trust” or “children’s trust” are also used in a trust which is not an A-B trust. This can be very confusing for a lay person.
Some married couples have A-B trusts which they do not need. If you and your spouse will never have more than $5.49 million, then you may want to get rid of your A-B trusts. Having an A-B trust when you don’t have an estate tax problem can actually cause an income tax problem for your children or other heirs. On the other hand, having an A-B trust can provide better asset protection for the surviving spouse and children.
Also, even if you have more than $5.49 million as a couple, in 2010 a law was passed allowing the “portability” of estate tax exemption to the surviving spouse. This means that after the first spouse dies, his or her unused estate tax exemption amount can be transferred to his or her spouse. However, this requires filing an estate tax return within 9 months of the date of death—even if no estate tax is owed. Thankfully, Hawaii is one of only two states that also allow for portability of the state estate tax exemption. Whether it’s better to take advantage of the income tax benefits of using portability or the asset protection benefits of using an A-B trust depends on your personal situation.
This article is for general information only. The facts of your case may change the advice given. Do not rely on the information in this article without consulting an estate planning specialist.