When planning to reduce federal estate taxes, married couples can make use of the AB Trust system in their estate planning. The AB Trust is set up in such a way that they can effectively transfer two times the maximum federal estate tax exemption to their heirs without encountering federal estate tax penalties. However, in states that collect separate estate tax, traditional AB Trust planning can cause part of the B Trust to be taxed when the first spouse dies.
Enter the ABC Trust system of estate planning for married couples, also known as "gap trust planning" and making the "state QTIP election." A handful of states allow the payment of both federal and state estate taxes to be deferred until after the surviving spouse's death.
So let's take a look at how an ABC Trust plan may work for your estate.
Traditional AB Trust Planning
In order to understand how the ABC Trust system works, you'll first need to understand how the AB Trust system works.
If a married couple has an AB Trust estate plan when the first spouse dies an amount equal to the federal estate tax exemption will be funded or moved into the B Trust, and anything over this amount will remain as the A Trust.
What does that accomplish? It uses up the deceased spouse's federal estate tax exemption. When the surviving spouse later dies, what is left in the B Trust won't be taxed as part of the surviving spouse's estate.
The surviving spouse will then be able to leave an amount equal to their own federal estate tax exemption to children or other beneficiaries. This process allows married couples to pass on two times the federal estate tax exemption free from estate tax encumbrance.
But what happens to the assets left in the A Trust? While these assets will be taxed as part of the surviving spouse's estate, payment of the tax will be deferred until after the surviving spouse passes.
Here's an example: Joe and Mary are worth $12 million, jointly. When Joe dies he has $6.25 million in his Revocable Living Trust and his estate plan includes AB Trust planning. Under these facts, $5.25 million will go into the B Trust under Mary's name and $1 million will remain in the A Trust, both for Mary's benefit. No federal estate tax will be due at the time of Joe's death. Instead, when Mary later dies the B Trust—originally holding $5.25 million—won't be taxed since it used up Joe's estate tax exemption and only what's left in the A Trust will be taxed as part of Mary's estate.
State Death Tax Gap and Use of ABC Trust Planning
Using the same facts above, what would happen if Joe and Mary lived in Oregon, which collects a separate state estate tax in addition to the federal estate tax and only offers a $1 million state exemption? Upon Joe's death $5.25 million should go into the B Trust and $1 million should go into the A Trust, but because the amount being funded into the B Trust greatly exceeds the $1 million Oregon estate tax exemption, there will be an Oregon estate tax bill of about $630,000 after Joe's death. Thus, $5.25 million will go into the B Trust, and only $370,000 will go into the A Trust.
If, however, Joe and Mary's estate plan is drafted to take advantage of the ABC Trust system, then instead Joe's estate will be divided up as follows:
- $1 million will go into the B Trust, exempt for state and federal purposes.
- $4.25 million will go into the C Trust, state QTIP only, exempt for federal purposes.
- $1 million will go into the A Trust, state and federal QTIP.
Thus, the ABC Trust plan will result in no Oregon or federal estate taxes being due at the time of Joe's death.
What Does the C Trust in ABC Trust Planning Do?
As illustrated above, the B Trust will hold the Oregon state estate tax exemption of $1 million, the C Trust will hold the difference between the Oregon estate tax exemption and federal estate tax exemption of $4.25 million, and the A Trust will hold what's left. Thus, the C Trust effectively defers the payment of both Oregon and federal estate taxes on the gap of $4.25 million between the Oregon and federal estate taxes until after the surviving spouse dies, but it still preserves the entire $5.25 million federal estate tax exemption for the next generation.