The once-popular AB-Trusts, a staple in estate planning when estate tax exemptions were significantly lower, might now be a ghost of financial burdens past, lurking in outdated estate plans. A deep dive into these trusts reveals how changing tax laws might be impacting your estate and beneficiaries negatively.
The Heyday of AB-Trusts
AB-Trusts were designed as a legal mechanism to help married couples minimize the estate tax impact by essentially doubling the estate tax exemption. When the federal estate tax exemption limits were much lower than today, these trusts offered a critical strategy to preserve wealth. Particularly from the 1980s through the early to mid-2000s, when exemptions were much lower than today, these trusts were almost a mandatory feature of estate planning for affluent families.
The Strategic Benefit of AB-Trusts
The primary appeal of AB-Trusts was their ability to save significant amounts in estate taxes. Here’s how they worked: upon the death of the first spouse, a portion of the estate (up to the exemption amount) was transferred into the B-Trust (or Bypass Trust). This portion was exempt from estate taxes at the time of the first spouse’s death and would also be exempt from the estate taxes of the surviving spouse, effectively shielding it from taxes until it passed onto the heirs.
The Hidden Drawback: Loss of Step-Up in Basis
While AB-Trusts were effective in saving estate taxes, they had a critical drawback: the loss of a step-up in basis on the assets held in the B-Trust upon the death of the surviving spouse. Under normal circumstances, assets inherited directly benefit from a step-up in basis to their market value at the time of the original owner’s death. This adjustment can significantly reduce capital gains taxes when the beneficiaries eventually sell these assets. However, with assets placed in an AB-Trust, the original cost basis is retained, which can lead to significant capital gains tax burdens for the heirs when they decide to sell.
Changing Times: The Diminished Relevance of AB-Trusts
Today, the estate tax exemption has increased dramatically—to $13.61 million per individual in 2024. This shift means that for most estates, particularly those under this threshold, the AB-Trust no longer offers the same financial advantage. Instead, it imposes an unnecessary capital gains tax burden on the heirs, due to the absence of a step-up in basis for assets in the B-Trust.
Should You Revisit Your Estate Plan?
If your estate plan includes an AB-Trust, it might be time to reconsider its utility. The current tax laws have shifted the landscape, making these trusts potentially more costly than beneficial. Consulting with an estate planning attorney can help you evaluate whether restructuring your estate plan might better serve the financial interests of your heirs, ensuring they inherit not just your wealth, but also a minimized tax burden.
Can an AB-Trust still be changed when the second parent (settlor) has passed away?
After the last settlor’s death, the trust becomes irrevocable. Irrevocable does not mean it cannot be changed using proper procedures.
In California, there are three avenues to make these changes:
- Decanting: As per the California decanting statute, a trustee may have the power to distribute the assets from the original trust to a second trust, effectively creating changes to the terms of the trust. Please note that while the decanting statute only became law on January 1, 2019, it is retroactively effective.
- Agreement among interested parties: If all trustees and beneficiaries agree, they can collectively decide to modify the terms of the trust. Probate Code 15404.
- Court intervention: If all beneficiaries consent they can seek a modification or termination of the trust through the probate court. 15403
The decanting statute contains a lot of detail, but here is the gist
If you’re considering modifying an AB-trust, the Uniform Trust Decanting Act provides a framework for doing so. Here are the key points relevant to modifying an AB-trust:
- Decanting Power: The Act allows an authorized fiduciary (such as a trustee) to distribute property from an original (first) trust to a new (second) trust or to modify the terms of the first trust. This can be done without the consent of the beneficiaries or court approval, provided certain conditions are met.
- Authorized Fiduciary’s Role: The authorized fiduciary must act in accordance with their fiduciary duties and the purpose of the first trust. They have the power to make these changes if they have discretion to distribute or direct a distribution of part or all of the principal of the first trust.
- Notification Requirements: The fiduciary must notify certain parties, including all qualified beneficiaries, settlors (if alive), and any fiduciaries of both the first and second trusts, at least 60 days before exercising the decanting power. This notice must include a description of how the decanting power will be exercised, the reasons for it, and the differences between the first and second trust.
- Conditions and Limitations: The exercise of decanting power is subject to restrictions that may be imposed by the terms of the first trust. For instance, the Act specifies that the second trust must not reduce any vested interests unless permitted by the trust’s terms.
- Court Involvement: While not always necessary, an authorized fiduciary can seek court approval for the exercise of decanting power, especially in complex situations or where there is potential for objection by beneficiaries.
- Purpose and Intent: The modifications must align with the original intent of the settlor unless otherwise provided in the trust document. The second trust must serve the same purposes as the first trust unless explicitly allowed to change.
- Tax Implications: Decanting must consider any potential tax implications, ensuring that changes do not adversely affect the tax status of the trust.
Conclusion
As we’ve seen, the landscape of estate planning, particularly concerning AB-Trusts, has evolved considerably due to significant changes in tax laws. AB-Trusts, once a strategic tool to shield assets from estate taxes, now often lead to complex situations where the beneficiaries might face unexpected capital gains tax burdens due to the non-adjustment of the basis upon inheritance.
Given these complexities and the potential financial implications, it is crucial for those with existing AB-Trusts—or those considering such estate planning tools—to seek the guidance of an experienced estate planner. An estate planner can provide invaluable assistance in navigating the intricate provisions of laws like the Uniform Trust Decanting Act. They can help assess whether modifications or a complete restructuring of your estate plan could more effectively align with your current financial goals and the tax realities of today.
Estate planning is not a one-time task but a dynamic process that should evolve as legal landscapes and personal circumstances change. An experienced estate planner will not only help you understand the nuances of your current plan but also ensure that any adjustments made are compliant, tax-efficient, and in the best interest of your heirs. Thus, engaging with a professional can help transform what might initially seem like a financial haunt into a well-structured legacy for your beneficiaries.
