To B or not to B? Should you keep your A/B Trust?

The American Taxpayer Relief Act signed earlier this year has favorable estate and gift tax rules.  Simply put, under the new laws, estate taxes will no longer be a big issue for most of our clients.   It’s estimated that 2,000 to 4,000 estates will be taxed in the entire US during 2013.  By comparison, there were more than 40,000 taxable estates annually from 1996 to 2001, and as recently as 2006 there were about 20,000 taxable estates. 

There are three main advantages to the current estate laws, compared to previous years:

1.   The laws are “permanent”

2.   Each person can shelter $5.25M from estate taxes in 2013 (increased for inflation in future years)

3.   Married couples can transfer any of their unused $5.25M exclusion to their surviving spouse – so together a married couple has a $10.5M estate exclusion.  This is known as portability.

The new law is actually pretty similar to what was in place in 2011 and 2012.  The big difference being the new law is “permanent,” meaning it doesn’t have a sunset provision that automatically changes the law in the future. Of course, nothing is forever in Washington and lawmakers can always pass new legislation (it’s already being tossed around).  In the chart below you can see a big difference between the planned sunset rules that were in place at the end of 2012, and current rules for 2013.

As compared to the planned sunset rules, the two big changes in 2013 are the higher exclusion amount and exclusion portability.  Portability was first introduced in the 2010 Tax Act to allow a spouse’s unused exclusion to later be used by a surviving spouse.  Prior to portability, you had to do careful planning to fully use each spouse’s exclusion. The most popular way was to fund a bypass trust (also known as a credit shelter trust or A/B trust) with assets at the first spouse’s death. 

Let’s look at a husband and wife example (had the new rules not become effective, and with the sunset rules in place). He has $2.5M in his name, she has $1M.  At the husband’s passing, he can transfer his entire $2.5M tax free to his wife using the marital deduction.  The wife would then have the entire $3.5M in her estate.  At her passing, the exemption would shield $1M from estate tax.  The other $2.5M would be her taxable estate, subject to 55% estate tax or $1.375M.  Had they funded a bypass trust at the husband’s death, they could have avoided a meaningful amount of that estate tax.  Rather than leaving $2.5M to his wife, he could have directed $1M to the bypass trust and the other $1.5M to her.  Now when the wife passes, her estate is reduced by the $1M in the bypass trust, saving $550,000 of estate tax.  Clearly, the bypass trust was worth the extra effort in this example.

The current laws have eliminated the need for this kind of bypass trust planning for many who used them simply to avoid estate tax.  Under today’s laws if the husband left his entire $2.5M to his wife directly, she would have an estate of $3.5M which could all pass tax-free at her death with the current $5.25M exemption amount.  There would be no tax motivation to use a bypass trust.  Even if their estate was larger, say the husband left the wife $6M at his death; portability still keeps them from owing estate tax.  Her estate would be worth $7M (her $1M plus husband’s $6M).  She can use her own exemption of $5.25M and her husband’s unused $5.25M exemption to pass the entire estate free of tax with nothing more than a simple will and filing an estate tax return.

A bypass trust is effective for estate tax purposes, but it comes with some negative trade-offs including additional costs, less flexibility for the surviving spouse, and some income tax consequences including compressed tax brackets and loss of stepped-up basis.  Now that portability is here to stay you may not need to worry about this trade-off.  You may be able to get the best of both worlds with a simplified estate plan. 

For most people, planning for purely estate tax purposes will no longer be a top priority.  However, estate planning as a whole continues to be very important, and there are still reasons that a trust may make sense, including: privacy, simplified estate administration, asset protection for future beneficiaries, spouse remarries, kids divorce, future asset growth, generation skipping bequest, state estate taxes, etc.

Bottom line: you may be able to accomplish your estate goals with a less complex structure than you currently have.  Now would be a good time to review your goals and involve your estate planning attorney to see whether any changes are needed.