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B. The “A/B Trust”

B. The Marital Deduction and Bypass Trust (the “A/B Trust”)

This is the tax planning cornerstone for many combined marital estates (i.e., all property owned by the husband, the wife, and jointly) worth over $2.0 million (in 2006 – 2008). This threshold for the usefulness of the “A/B Trust” will increase over the next few years, as the amount of each individual’s shelter against the federal estate tax increases. (See “F.Y.I.” below.) With the A/B Trust arrangement, a married couple can pass a combined estate of $4.0 million or less to their children without any federal estate tax, assuming both spouses died in 2006 through 2008.

F.Y.I. The principal of this technique remains valid under the 2001 Tax Relief Act. Many A/B Trusts now in existence use flexible language that will automatically adjust the terms of the Trust to reflect whatever the new shelter amount is in a given year. (That might or might not be what you want, however.) We will continue to refer to “$2.0 million” simply to have a figure for discussion.

People invariably get confused when this (or any) Trust arrangement is first explained. Rest assured, this is not nearly as complicated as rocket science – but it is just as unfamiliar. That is what the problem is, and why a little study is necessary. The very concept of a “Trust” is not something most of us have any experience with at all, and we cannot show you a picture. A Trust is an intangible creature of the law. But it is an entity that can own real things. That is the key.

Remember, just think of a Trust as a vessel, or “holding tank,” into which money and property can be “poured.” This is done by transferring it to the Trustee. Usually, husband and wife serve as their own Trustees, at least initially. A formal transfer of property to themselves – as Trustees – is still required, however.

All the rules and the scheme of ultimate property distribution are decided in advance, with the help of a lawyer, and written into the Trust document. Most people specify the broad outline of their intentions at the time the Trust is prepared, but leave themselves (or whoever else wears the hat of Trustee) great discretion as to all kinds of details. Flexibility later on makes people more comfortable today in implementing the “A/B” plan.

While both spouses are alive, in the community property states, there can be a single Initial Trust, that is revocable and completely in their control. It is similar to, and serves all the purposes of the “simple” living Trust, discussed earlier. The Initial Trust ends at the first death, by splitting into two new Trusts (“A” and “B”). (This happens simply because there is a paragraph in the Initial Trust stating that, upon the first death, the “A” and “B” Trusts are to be created. If separate husband and wife Trusts have been set up, it is only the original Trust of the deceased spouse that ends at this point, and the “A” and “B” Trusts are still created.)

Most planners in the other (“common law,” rather than “community property”) states have preferred to use separate trusts for the husband and wife. Although a joint husband-wife trust is simpler to understand and set up, there are good (but complicated) tax reasons why attorneys in common law states have not felt comfortable with the joint trust approach. (A couple of IRS rulings in 2002, however, have begun to increase their comfort level.) In any event, the tax-saving principles described for the joint trust here are the same in separate trust situations.

The Trustee (usually, the survivor) divides the Initial Trust property and places some in each of the two, “A” and “B.” The “B” Trust (for the “Below-the-ground” spouse) is irrevocable, and makes use of the deceased spouse’s estate tax shelter. That is the tax objective here of the “B” Trust. The “B” Trust is established (usually) for the ultimate benefit of children and (eventually) grandchildren.

The Trust is worded so that the federal estate tax “shelter limit” (or “credit shelter” or “applicable exclusion amount”) is placed in the “B” Trust. (For 2006 – 2008, $2.0 million.) Remember, this shelter must be used at the time of the first death, or it is wasted. (The “B” Trust is also called the “Bypass Trust,” because property in it bypasses taxation.)

The tax goal of the “B” Trust is to get this money out of the couple’s combined estate, so that it escapes estate taxation after the second spouse’s death, too – not just the first. To illustrate how this works, let us look at a common – and costly – alternative arrangement.

If a couple uses simple Wills alone, the first spouse to die usually passes his/her entire estate to the survivor with no tax at all, because of the unlimited marital deduction. But in so doing, the chance to use one of the couple’s two $2.0 million tax shelters is lost. Upon the second death, only the second spouse’s shelter is available. Every dollar over $2.0 million will be taxed at rates that start around 40% !

Of course, sometimes the estate is large enough so that the surviving spouse can afford to part with $2.0 million upon the first death. If so, no Trust is necessary to make use of the decedent’s shelter. One of the decedent’s options is to just make an outright bequest of any amount to anybody. The first $2.0 million would be sheltered from federal gift and estate tax.

Most families, however, face a major dilemma: Tax planning is fine, but Mom and Dad usually do not want the survivor of them to lose the benefit and security of that $2.0 million. Keeping control of the full family estate is a much higher priority than tax savings in most family situations.

Fortunately, the law allows the survivor to retain nearly full control over the “B” Trust for practical purposes, and still take advantage of the $2.0 million tax shelter. So, property in the “B” Trust will not be included in the estate of the second spouse to die, and thus escapes estate tax. Yet the surviving spouse’s rights to property in the “B” Trust include:

– All annual income produced by the “B” Trust.

– The annual, but non-cumulative right to withdraw the greater of $5,000 or 5% of the “B” Trust principal, for any reason. (“Mad money.”)

– The right to invade this principal, if necessary, but limited to an “ascertainable standard” relating to the survivor’s “health, education, maintenance or support.” (Precise wording of the Trust is absolutely crucial here to avoid tax trouble.)

What is the survivor not allowed to do with “B” Trust funds? Really, the only prohibited expenditures would probably not be very likely, anyway. “B” Trust money should not be used, for example, to buy a boat or a collection of antiques. (The “A” Trust could be used for such purchases, however.)

As a practical matter, the limitations of the “B” Trust are unlikely to constrain the way the surviving spouse chooses or can afford to live.

The “A” Trust (for the “Above-the-ground” spouse) is also called the “Marital Deduction Trust.” Property in this Trust is absolutely and completely under the control of the surviving spouse, who can even revoke the Trust at any time. If somebody else is serving as Trustee, he/she/it must take orders from the survivor, if given. Alternatively, the survivor can just fire the Trustee.

The reason the A/B Trust arrangement is so useful is that it provides a means of doing two things: First, it takes advantage of both spouses’ $2.0 million shelter from federal estate tax – not just one. Secondly, it achieves this tax goal while allowing the surviving spouse maximal use and control of the entire family estate.

The $2.0 million shelter is a “use it or lose it” break available only at the time of each person’s death. The “B” Trust is a way for the first-to-die spouse to “stake his/her claim” to the tax shelter, to avoid losing it. That is where the big tax benefit comes from.

Strictly from the standpoint of estate tax, the “A” Trust is unnecessary. The survivor has total control over the “A” Trust, and we recall the basic rule presented earlier: There is no tax advantage in that situation. But the other significant advantages of a Trust (e.g., professional investment expertise; management in case of disability) still weigh in favor of using the “A” Trust. (The alternative is to simply use a “B” Trust for its tax advantage, but give all other property to the surviving spouse outright, with no “A” Trust at all.)

BEWARE ! For any Trust to work at all, it must own property; there must be a formal transfer to it. If the A/B Trust is to be established in a Will, rather than as part of a living Trust, an important step must be taken to get the most (or maybe any) benefit out of each spouse’s $2.0 million shelter: Each spouse must own $2.0 million in assets -separately.

This might involve some shuffling of title documents, but it is essential. Why? Remember that, in many families, all property is owned by Mom and Dad jointly, with right of survivorship. If so, this property passes at death, outside the Will (no matter what kind of Will it is). Nothing would then be left to place in the Trusts, and the whole plan would completely fail.

BEWARE ! In community property states, a spouse might have a half interest in an asset, even if his/her name is not on the document of ownership. Therefore, any Trust in one of these states should be drafted with particular care to allow allocation of assets appropriately.

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