5.2 Types of Trusts

• Library: A Lawyer's Guide to Estate Planning: Fundamentals for the Legal Practitioner (ABA) (2018 Ed.)

5.2 Types of Trusts

5.21 A-B Trust

The A-B trust is a basic approach in estate planning used prior to the American Taxpayer Relief Act of 2012, which was designed to lessen the federal estate taxes owed by an estate. The A trust is sometimes referred to as the marital trust; and the B trust is often referred to as the credit shelter, by-pass, or family trust. Prior law required a married couple to use the marital deduction prior to using the exclusion amount ($11,200,000 in 2018).¹ Because the marital deduction eliminated the estate taxes on property passing to the surviving spouse, the exclusion amount was not used in the estate of the first spouse to die when the entire estate passed from the deceased spouse to the surviving spouse. The exclusion amount of the deceased spouse was, in effect, lost, resulting in the surviving spouse's estate being limited to his or her own exclusion amount. To obtain the use of both exclusion amounts, the "A-B Trust approach" was used.

In the A-B Trust approach, an estate is placed in trust and divided into two separate trusts termed Trust A and Trust B. Trust A must qualify for the federal estate tax marital deduction, whereas Trust B is designed intentionally not to qualify. If a Trust A is not desired, these assets can be given outright to the surviving spouse. Trust B is intended to equal the exclusion amount in the year of death, with the balance of the estate passing into Trust A.² The estate tax owed on Trust B is offset by the unified credit, thus resulting in no estate tax on Trust B. Because Trust A (or Share A if a trust is not desired) qualifies for the marital deduction, no estate tax is owed on it. A third option using a QTIP trust rather than a Trust A or Share A is discussed at 5.22.

If Trusts A and B are used, the surviving spouse can receive the entire income from both trusts if desired, but he or she must receive the income at least annually from Trust A. The principal from both trusts can be expended for the surviving spouse if necessary for his or her health care, maintenance, and support. Normally, the surviving spouse must be granted a general power of appointment over Trust A, but this is not essential if the QTIP trust discussed in 5.22 is elected. On the death of the surviving spouse, Trust A and that spouse's own property are subject to the estate tax on his or her own estate. The Trust B assets pass to the remaindermen of Trust B without any federal estate tax. Therein lie the estate tax savings. These savings will result even though the surviving spouse had the benefit of income and principal from Trust B. (There are a number of intricacies in an A-B trust estate plan. The discussions in Chapters 6 and 7 should be helpful, as should the annotated wills and trusts provided in Chapter 15 at 15.3 and 15.4.) Two additional resources providing drafting forms are R. Hunt, Estate Planning Forms (ABA, 2009) and J. Horn, Flexible Trusts and Estates for Uncertain Times (5th ed.; ABA, 2014).

Current law does not require this awkward approach to tax planning. The current law introduced a concept known as "portability," which simply means that the unused exclusion amount from the first spouse's estate can be transferred to the second spouse to be added to her or his exclusion amount.³ This sensible and overdue legislative change enables a couple to have the benefit of both exclusion amounts without the complicated trust drafting that was required under the A-B trust planning approach. All that is required to ensure the portability option is the filing of a federal estate tax return making this election for the estate of the first spouse to die. Although the A-B Trust approach is not utilized as much today as it was under the prior law, there are still situations in which it will be the preferred planning approach. For example, if there is expected to be significant asset growth in the estate assets between the time of the death of the first spouse and the death of the surviving spouse, then this planning approach is still a wise one to use. In estates that are large enough to owe a federal estate tax, the tax rate is 40%. An estate today that is approximately $11,000,000 would not result in any federal estate tax at either death. However, if some of those estate assets grew significantly in value, it would have been a wise plan to place the growth assets in the B trust, as those assets would not be taxable at the death of the second spouse. If those assets grow in value in excess of the exclusion amount ($11,200,000 in 2018), then 40% of the growth will escape estate taxes. For example, if the assets placed in the B trust increased by $5,000,000 over the years between the death of the first spouse and the second spouse to die, then an estate tax savings of $2,000,000 would be possible. This savings is partially offset by a capital gains income tax on the gain above the income tax cost basis when the assets are sold. Further, if the assets did not grow in value, there is no advantage to the B trust. Indeed, there is a disadvantage because all of the assets owned by the second spouse to die will receive a step-up basis in the income tax costs basis, which will usually lessen income taxes.

Planning Pointer 1

Because it is difficult to know at the time of drafting the estate planning documents whether the estate tax or the income savings will be the bigger issue, a useful approach is to will all of the property outright to the surviving spouse or into an A trust or a QTIP trust, and then provide that any disclaimed assets will then pass into the B trust. In this way a decision can be made at the first death as to whether to pursue the income tax savings option or the estate tax savings option. An excellent ABA resource is C. Cline, Disclaimers in Estate Planning (2d ed.; ABA, 2012).

5.22 QTIP Trust

The qualified terminable interest property (QTIP) trust makes use of the marital deduction in much the same way as does the A-B Trust approach. The primary difference is that the QTIP trust does not grant the surviving spouse a general power of appointment over the A trust. The B trust remains the same.

A general power of appointment was traditionally granted to the surviving spouse so that the A trust could qualify for the marital deduction. Otherwise, the A trust was termed a terminable interest, for which no marital deduction was allowed. An amendment to the estate tax law effective in 1982 permits the marital deduction for most terminable interests if so elected by the executor.⁴

In a QTIP trust, the surviving spouse must be given income for lifetime from the A trust, but principal distributions can be restricted as desired by the settlor. The surviving spouse is not given a general power of appointment over the trust. The terms of the settlor's trust determine the manner in which the trust will be distributed following the death of the surviving spouse.

The QTIP trust is particularly important when planning estates for spouses who each have children from an earlier marriage. The settlor can determine the estate distribution and know that it will not be modified at a later date by the surviving spouse's exercise of a power of appointment in favor of his or her own children. The QTIP trust also prevents the surviving spouse from transferring the A trust to a new spouse should the surviving spouse remarry. See 15.3 regarding inclusion of QTIP trust provisions in the A-B trust.

5.23 Premarital Trust

A widow or widower often is concerned about the rights of...