What Is an A-B Trust?

Establishing a trust allows individuals and families to protect their assets and reduce the tax burden on their estate once they pass away. There are, however, many different types, each with unique benefits and functions. A notable option families may choose to set up is an A-B trust, also known as marital and bypass trust. By using this, couples can help ensure they reduce the impact of estate taxes and take care of their surviving spouse.

In this article, we’ll provide a comprehensive overview of A-B trusts and how they work. Specifically, we’ll explain why you might want to establish one for your estate, including their tax advantages, as well as potential drawbacks to keep in mind. Finally, we’ll touch on setting one up and the importance of having an estate planning professional in your corner.

How A-B Trusts Work

An A-B trust enables married couples to optimize the tax burden on their estate. Like other trusts, it involves placing assets in the control of a trustee for the eventual benefit of one or multiple beneficiaries. A core benefit of an A-B setup, though, is that a surviving spouse can avoid paying estate taxes while receiving income from a deceased partner’s trust.

The A-B arrangement begins as a single trust created by you and your significant other during your marriage. According to Alexander M. Evans, estate planning attorney at Turke & Steil, LLP, once the first spouse passes away, it breaks into two core parts—trust A (known as a marital or survivor trust) and trust B (known as a bypass or credit shelter trust).

“When the first spouse dies, the A-B trust is ‘split,’” Evans explains. “The A Trust remains under the control of the surviving spouse and typically contains that spouse’s assets. The B Trust holds the deceased spouse’s share of assets, which are generally sheltered from estate taxes because they utilize the deceased spouse’s estate tax exemption.”

Unlike the A trust, which can still be modified or taken back, the deceased spouse’s trust is irrevocable, meaning the surviving partner can’t alter or cancel the terms. Even so, a spouse can still benefit from the B trust indefinitely after their spouse has passed away, even if they can’t directly tap into the assets or the funds it houses as they would in a revocable trust. However, the specifics of this may vary depending on the situation and terms of the arrangement.

“The surviving spouse can usually access income or certain benefits from the B Trust, but the principal typically cannot be touched,” Evans says. “After the surviving spouse dies, the assets in both trusts are passed on to the beneficiaries, such as the couple’s children.”

Why Establish an A-B Trust

There are many reasons an A-B trust can be an effective component of your estate plan. For example, they can allow you to gain control of your assets after you or a spouse passes away. They can also provide an opportunity to reduce the taxable portion of your estate.

The arrangement “is especially useful for couples with substantial assets who want to take advantage of both spouses’ federal estate tax exemptions, which could potentially double the amount of assets passed to beneficiaries tax-free,” notes Evans. “It also ensures that when the second spouse passes, the assets are distributed according to the wishes of both spouses, rather than being fully controlled by the surviving spouse.”

Below is a breakdown of the advantages of setting up an A-B trust:

Asset Protection and Control

One of the top benefits of A-B trusts is that they let you and your significant other control what happens to your assets if either one of you passes away. That is, the arrangement protects the assets of the deceased spouse in an irrevocable trust, which keeps them safe from creditors, litigation, or even the living spouse attempting to modify the terms of the trust or access the contents.

According to Evans, “Couples can ensure that the deceased spouse’s wishes for asset distribution are honored, preventing the surviving spouse from making substantial changes.”

Tax Advantages

A-B trusts are also valuable because of the tax benefits they offer, especially in their ability to let a surviving spouse receive income without incurring estate tax. However, another important advantage is that it maximizes exemption rules by shielding a portion of the estate against taxes in an irrevocable trust.

“When the first spouse dies, the assets in the B Trust (the deceased spouse’s trust) are not counted toward the surviving spouse’s estate, meaning they are shielded from estate taxes. This reduces or eliminates the estate tax liability when the second spouse dies,” describes Evans. “Essentially, the B Trust can pass assets to beneficiaries free from estate taxes, which can be significant for high-net-worth couples.”

Income for Surviving Spouse

Finally, A-B arrangements are beneficial because the surviving spouse can still receive income and benefits from the assets in the B trust. Even though some of the assets belonging to the deceased spouse aren’t accessible, this can allow a former spouse to have a reliable source of income.

In that way, married couples can use an A-B setup to plan for income and ensure that the living partner is taken care of. Even if family members contend against it, the irrevocable nature of the deceased spouse’s trust protects against changes to the living spouse’s claim to income.

Are There Any Disadvantages?

While establishing an A-B trust can have a range of unique benefits regarding income planning, tax optimization, and asset protection, it can have drawbacks. This is especially the case if you’re not looking for a more complex estate plan and would like to save money on advisory or management fees.

Here are some pitfalls to keep in mind:

• Cost. Trusts can cost a premium to set up and manage, requiring consulting with professionals.
• Complexity of establishing. While A-B trusts are a well-known option for married couples, they can be more complicated than creating a simpler revocable or irrevocable trust.
• Inflexible. Per Evans, “it can be difficult to make changes” once the trust breaks up into parts A and B. He points out this “may be challenging if circumstances change, like the need for long-term care or significant medical expenses.”
• Less common than before. It isn’t as common as before because, as Evans highlights, “changes in estate tax laws have increased the estate tax exemption significantly,” which means that “many couples can now pass substantial assets to their heirs without being subject to federal estate taxes.”

Setting Up an A-B Trust

As mentioned, setting up an A-B trust can be more complex than a typical arrangement. It will require a balanced and fair approach for a married couple to decide which assets should be allocated to each part of the trust. And, unless this has been previously defined in a prenuptial agreement between both partners, it will often be most beneficial to go through the entire process with the help of an estate planning professional, such as an attorney or financial advisor.

When building an A-B trust, the first part will be drafting the documents, including selecting beneficiaries and deciding how to allocate assets and what the split will look like once a spouse passes away. According to Evans, there are three primary options for the latter, which he describes in detail below:

Disclaimer Trust: In this option, when the first spouse dies, all assets initially pass to the surviving spouse. However, the surviving spouse has the choice to “disclaim” or refuse some or all of the inheritance within a certain time frame. Any disclaimed assets are then moved into the B Trust. This approach provides flexibility, allowing the surviving spouse to decide based on the estate size and tax laws at the time of death.

Clayton Election: The Clayton Election allows the allocation of assets between the A and B trusts to be determined after the first spouse’s death. The executor can decide how much to allocate to the B Trust to maximize tax benefits, or they can allocate nothing if the tax situation doesn’t warrant it. This option provides post-mortem flexibility in determining how to best split the assets for tax efficiency.

Mandatory Funding: In some A-B trusts, a set formula or requirement automatically divides the assets into the A and B trusts based on the estate tax exemption limit at the time of death. For example, the B Trust might automatically receive up to the estate tax exemption limit, while the rest goes to the A Trust.

Ultimately, an estate planning expert will be able to guide you through the multiple ways to structure the trust and how to choose a trustee to manage your assets. As noted, the former can be a trusted legal professional or a financial advisor. In an ideal setup, you might have both who can work together to design a plan for you.

Therefore, Evans recommends that “while an A-B trust offers tax advantages and control, it is important to review all estate planning options regularly, especially in light of changing laws and family circumstances.” He continues, “Working with an experienced estate planning attorney will help ensure your plan is tailored to meet your financial goals and protect your loved ones.”