In the past, the most popular way to take advantage of the federal exemption for both spouses was to set up and fund a revocable A-B Trust. For larger estates, the maximum federal exemption amount would go into a B Trust (“B” for below ground); the balance of deceased’s estate would go into the A Trust, usually for the exclusive benefit of the surviving trust.

 

Once funded, the B Trust became irrevocable and had its own federal tax identification number. The B Trust was usually written to provide income for the surviving spouse with assets to be ultimately distributed after the surviving spouse died, typically to the original grantors’ surviving children. This gave each spouse some peace of mind—if the surviving spouse remarried, B Trust assets would not eventually go to the new couple’s children or to the new spouse. A Trust assets, however, were freely available to the surviving spouse. The survivor could gift away these assets, spend them frivolously, or add to A Trust assets at anytime.

 

Most A-B Trusts were worded so the surviving spouse could use B Trust assets for “health, education, maintenance, and support.” This broad phrase covered almost everything except gifting assets to others. Additionally, B Trust frequently contained a provision allowing the surviving spouse to withdraw up to an additional $5,000 per year, or 5% of B Trust assets, whichever was greater, to be used for any purpose.

 

A major advantage of the B Trust was (and is) that it could grow an unlimited amount and not be subject to estate taxes upon its final distribution. The reasoning was the federal government tried to tax it once (when first spouse died) and could not attempt to tax it at a later time.

 

For example, Mr. and Mrs. Jones set up an A-B Trust and funded it with $30 million of assets. Mr. Jones died shortly thereafter. Upon his death, the revocable trust became two trusts: an irrevocable B Trust funded with the maximum federal exemption (call it $5.3 million) and a revocable A Trust that was the sole property of Mrs. Jones, with an initial worth of $24.7 million. When Mrs. Jones died, the B Trust was worth $12 million. The B Trust is not subject to estate taxes, regardless of the size of Mrs. Jones’ estate at death.

 

Today, the federal estate tax exemption has a spousal portability feature—whatever the first deceased spouse did not use is tacked onto the surviving spouse’s amount. For example, Mr. and Mrs. Smith have an estate worth $10 million. The couple has an estate plan (will and/or trust) that provides for the surviving spouse to inherit everything; upon the death of the surviving spouse, the estate is go be divided among two children, three grandchildren, and a next door neighbor.

 

When Mrs. Smith died she had not used any of her lifetime exclusion (meaning any gifts she made each year while alive were not > the annual exclusion). She died with a will that left all of her assets to Mr. Smith. Since gifts and inheritances between spouses are not subject to a federal tax, Mrs. Smith died with her lifetime exemption fully intact. Because of this, Mr. Smith now has a lifetime exemption of $10.6+ million (his $5.3 + $5.3 from his wife), an exemption that will receive a CPI increase each year.

 

As you can see from the example above, an A-B Trust for estates worth < the combined spousal federal exemption have no tax savings benefit. However, an A-B Trust can still be an important estate planning tool for the following reasons: [1] peace of mind that some assets will not go to a subsequent spouse (or his/her children); [2] insulation from certain lawsuits (B Trust assets cannot be used to settle a lawsuit that involves the surviving spouse); and [3] possible protection from financial ruin (surviving spouse may only have limited access to B Trust assets).