Estate Tax & A-B Trusts

Marcia's Story: Learn from Marcia's case.

Estate tax differs from income tax in that income tax is owed every year on any incoming revenue.
Estate tax is owed on the net value of your estate (if that estate is above a certain value) at the time of your death if you leave your assets to any beneficiary other than your spouse. Essentially your estate is made up of everything you own: life insurance proceeds, your IRA, your cars, your jewelry, etc., less any debts you may owe on that property. If your home is worth $200,000 but you still owe $95,000 on your mortgage, only $105,000 would be included in your net estate from that property.

How much can you pass on to beneficiaries before estate tax is owed?
Currently you can give or bequeath $600,000 [Janet's note: As of 2005, the amount rose to $1,500,000.] to your beneficiaries free of estate tax. Any amount over that and your beneficiaries will pay dearly [Janet's note: Almost 50% in estate tax].

How can you reduce estate taxes by gifting?
To reduce estate taxes to beneficiaries, if your estate is larger than the allowable amount, you might want to reduce the size of the estate by gifting money. In Chapter Three we discuss the allowable $10,000 per person per year. But did you know that you can pay college tuition directly to a college in any amount, even if it exceeds $10,000, and not pay any additional gift tax? For instance, you can gift a grandchild, or anyone else, $10,000 a year plus pay her annual college tuition, which can be sizeable, and reduce the size of your estate. [Janet's note: As of 2007, the dollar amount became $12,000.]

How to Avoid Estate Tax

By setting up an A-B trust while both partners are alive you can double the amount of money you can leave to your beneficiaries free of estate taxes. Getting back to Marcia's parents: Had they simply set up an A-B trust, everything would have been left to Marcia without a penny owed on the estate. She could have kept her house in Bolinas and all the money from the sale of the lots to generate income for her to live a comfortable lifestyle. Instead, she paid $235,000 in estate taxes.

How does an A-B trust differ from a revocable living trust?
A revocable living trust is simply a vehicle that helps you transfer legal title quickly and effectively. It eliminates probate fees, court costs, time delays, etc., but it is not relevant to reducing any estate tax liability.
An A-B trust for spouses was devised to reduce your estate tax liability. It can currently shelter up to $1.2 million [Janet's note: As of 2005, $3 million]. An A-B trust can be created as part of a revocable trust or part of a will as a testamentary trust (a trust set forth in a will that only takes on its legal existence after being authenticated as part of the probate court process). However, a testamentary trust created in a will still has to be probated and, therefore, is not advisable.
Here is how it would have worked for Marcia's parents:
When Marcia's father died, his "half" of the $1.2 million estate, or $600,000, would have passed into the "A" portion of the trust rather than directly to Marcia's mother. Marcia's mother would be the trustee of that trust. She would receive all the income the trust produced. If Marcia's mother used up all her "half" of the funds (the "B" part of the trust), she could take as much of the principal from the "A" portion of the trust as needed.* For the surviving spouse, the reality of the A-B trust should be that money is handled no differently than if it wasn't in the trust. When the mother dies, the A and B portions both go to Marcia.

* The term "as needed" is defined as an "ascertainable standard," especially for health, support, education, or maintenance.

Here is where the difference comes into play. Because money or property went directly from Marcia's father into the trust, it never became a part of her mother's estate. Any money coming to Marcia from the "A" portion of the trust had the father's credit applied to it. Her mother's half of the estate, also valued at $600,000, was allowed to pass down to Marcia using her mother's credit. In this way Marcia received the maximum amount of $600,000 from each parent. If the father had left his $600,000 outright to the mother, no tax would be due at the time of his death because there is no tax between spouses. However, at the time the mother died, the entire $1.2 million would be in her estate and she could pass only $600,000, estate-tax-free, with the result that Marcia would owe $235,000 in estate tax. The A-B trust prevents this from happening. The end result is that Marcia would have received all $1.2 million in property and owed nothing in estate taxes had her parents created an A-B trust. This is standard estate planning but requires that both partners be alive at the time the plan is created.
You may feel this is not worth investigating because your net estate is not $600,000, but you must make sure you total everything you own - the house, life insurance, pensions, retirement plans with death benefits, all proceeds payable at your death, all investments, art collections, antiques, everything. You may be surprised if you own a home how quickly everything adds up. Marcia was surprised to learn that the house and the land were valued so highly. If you have done a realistic calculation and you still feel your estate value falls short of the $600,000 figure, beware of any reduction in the estate tax exemption. If the law changes, be ready to establish an A-B trust.

Is an A-B trust just for a husband and wife?
Unmarried couples, same-sex couples, or just two friends can get the same benefit up to $1.2 million [Janet's note: As of 2005, $3 million] by establishing separate trusts, which remain intact until both partners have died.

Who benefits from an A-B trust?
Ultimately it is your children, or other named beneficiaries, who will reap the benefit of this trust. Remember, a deceased husband or wife can pass assets to the other without any estate tax at all. This is known as the unlimited marital deduction.

TIP: Because the trust is created for the benefit of your heirs, or others who will get your property after you are both gone, why not ask them to reimburse you for the cost of setting up the trust? Marcia would have gladly paid $2,500 to save more than $235,000.

Estate Tax Exemption and Rate

2001: $675,000
Tax rate: 55%

2002: $1 million
Tax rate: 50%

2003: $1 million
Tax rate: 49%

2004: $1.5 million
Tax rate: 48%

2005: $1.5 million
Tax rate: 47%

2006: $2 million
Tax rate: 46%

2007: $2 million
Tax rate: 45%

2008: $2 million
Tax rate: 45%

2009: $3.5 million
Tax rate: 45%

2010: repealed
Tax rate: 0%

2011: President-elect Obama has suggested freezing the estate tax exemption at $3.5 million.