Separate trusts, sometimes known as “AB trusts” or “credit shelter trusts,” were designed to help married couples minimize or avoid estate taxes, honor the wishes of the first spouse to die, and protect assets for the benefit of heirs, especially in blended families. However, in recent years, our estate planning attorneys have been asked on an increasingly frequent basis if these types of trusts are necessary in light of changes to the law. Are separate trusts becoming obsolete?
It’s true that the primary purpose for separate trusts isn’t as pressing as it once was. The Tax Cuts and Jobs Act (TCJA) of 2017 significantly increased the amount of the estate tax exemption, reducing the number of estates that are likely to be exposed to estate taxation. The exemption is $13.61 million per individual in 2024. If one spouse does not make use of their entire exemption amount, it is “portable” to the other spouse with proper planning. This means that it is carried over to the surviving spouse.
The increase in the estate tax exemption is supposed to “sunset” to 2017 levels (adjusted for inflation) after 2025. However, it is unknown what exact amount the exemption will decrease to and even if the increased exemption amount will be extended.
The bottom line is that fewer couples may need to rely on separate trusts to avoid estate taxes. But that doesn’t mean they aren’t still useful.
What Are Separate Trusts, and How Do They Work?
Separate trusts involve a trust structure in which a married couple creates a trust, which is then split into two distinct trusts when the first spouse dies. One of the trusts is a “bypass trust,” so called because it is intended to bypass the estate of the surviving spouse.
The bypass trust is funded with assets up to the amount of federal estate tax exemption available to the deceased spouse. Assets in the bypass trust benefit the surviving spouse during his or her lifetime.Because the assets in this trust do not become part of the surviving spouse’s estate (regardless of how much they may grow), they are not subject to estate tax upon his or her death.
The second trust is called a “marital trust.” It is funded with any assets above and beyond the amount of the estate tax exemption; it qualifies for the unlimited marital deduction. The result is that no estate taxes are due on the death of the first spouse.
However, the assets in the marital trust are included in the estate of the surviving spouse upon his or her death, potentially exposing them to estate tax. However, those assets receive a step-up in basis upon the death of the surviving spouse. The step-up in basis doesn’t affect estate tax exposure, but could significantly reduce capital gains tax owed if the beneficiary of the trust sells the assets.
Is There Still a Reason to Use Separate Trusts?
Even with the possibility that the estate tax exemption will remain high, and the fact that unused exemption is “portable” from one spouse to the other, there are still reasons to consider separate trusts.
Asset Protection
Although a surviving spouse can receive income (and perhaps principal) from a bypass trust, those assets are not part of the estate of the surviving spouse and, as a general rule, are shielded from that spouse’s creditors. That can be meaningful if, say, the surviving spouse has a lot of debt or might be sued for some reason.
More relevant in many families, however, is the possibility that the surviving spouse will remarry. In that scenario, the bypass trust serves another function. It keeps trust assets from being used by the surviving spouse’s new spouse, and from becoming commingled with the new couple’s marital assets. That protection preserves the assets in the bypass trust for the heirs of the first spouse to die—especially relevant if those heirs are not also children or grandchildren of the surviving spouse.
Control Over Distribution of Assets
Even if the surviving spouse doesn’t remarry, without the separate trusts, there is always the possibility that he or she could spend down all the assets inherited from the deceased spouse, leaving little or nothing for the deceased spouse’s children and grandchildren. If the spouses had children from previous relationships, the surviving spouse could, in the absence of separate trusts, funnel assets to his or her own children at the expense of the deceased spouse’s children.
The creation of the bypass trust protects the assets of the first spouse to die for his or her chosen beneficiaries.
Protection From an Uncertain Tax Future
No one has a crystal ball to predict how the tax laws will change. Creating separate trusts now may ensure protection from estate taxes in the event that the exemption amount is reduced in the future or portability is eliminated.
These trusts are not the only way to protect assets or avoid estate tax. An experienced estate planning attorney can help you explore the options available to you given your unique circumstances and needs.
Get Help With Your Estate Plan
The knowledgeable estate planning attorneys at Barron, Rosenberg, Mayoras & Mayoras work with clients who are concerned about protecting their spouses, their assets, and their heirs. Schedule a consultation today by calling (248) 213-9514 in Michigan or (941) 222-2199 in Florida to learn how we can assist you. You can also use our simple online contact form.