What Are ABC Trusts and Their Tax Implications?
State Estate Tax Planning for Married Couples
When planning to reduce federal estate taxes, married couples can make use of the AB Trust system to effectively transfer two times the federal estate tax exemption to their heirs free from federal estate taxes. But in most states that collect their own 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," which in a handful of states allows payment of both federal and state estate taxes to be deferred until after the surviving spouse's death.
So how does ABC Trust planning work?
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, then when the first spouse dies an amount equal to the federal estate tax exemption will be funded into the B Trust and anything over this amount will be funded into the A Trust. What does this do? It uses up the deceased spouse's federal estate tax exemption so that when the surviving spouse later dies, what's left in the B Trust won't be taxed in 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, thereby allowing married couples to pass on two times the federal estate tax exemption free from estate taxes.
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 dies.
Here's an example: Joe and Mary are worth $12 million, and when Joe dies in 2013 he has $6.25 million in his separate name or Revocable Living Trust and his estate plan includes AB Trust planning. Under these facts, $5.25 million will go into Joe's B Trust and $1 million will go into Joe's A Trust, both for Mary's benefit, and no federal estate tax will be due as a result of Joe's death. Instead, when Mary later dies the B Trust 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 Tennessee, which collects a separate state estate tax in addition to the federal estate tax and only offers a $1.25 million state exemption in 2013? 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 $1.25 million Tennessee estate tax exemption, there will be a Tennessee estate tax bill of about $498,750 after Joe's death.
Thus, $5.25 million will go into the B Trust and only $501,250 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:
- $1.25 million will go into the B Trust - exempt for state and federal purposes
- $4 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 thus result in no Tennessee 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 Tennessee state estate tax exemption of $1 million, the C Trust will hold the difference between the Tennessee estate tax exemption and federal estate tax exemption of $4 million, and the A Trust will hold what's left. Thus, the C Trust effectively defers the payment of both Tennessee and federal estate taxes on the gap of $4 million between the Tennessee and federal estate taxes until after the surviving spouse dies, but still preserves the entire $5.25 million federal estate tax exemption for the next generation.