Marital Trusts, Estate Tax Issues, and Blended Families

We’ve discussed why an estate might need to file an estate tax return even if the estate doesn’t owe any tax in a previous post. And that recommendation still holds. But let’s look at another way an estate plan would need to utilize the IRS rules for the benefit of a person’s beneficiaries.

A standard tool for planning for families as the Marital or AB Trust. Essentially, a married couple creates each of their wills with provisions for 2 trusts to be created at the death of one of the spouses, the A Trust and the B Trust. The A and B Trusts have differing rules and guidelines, as well as different methods of funding and different goals, in an effort to maximize the use of the estate tax exemption for a married couple.

Here’s the rub, though: depending on the state of politics (who’s in the White House, who dominates the House and Senate, and the prevailing political winds) the estate tax exclusion amounts could change. Any planning you do needs to attempt to address the possibility of future law changes to the extent possible.

With a Marital AB Trust situation, the planning goes basically as follows: Spouse 1 and Spouse 2 execute wills that create (at least) 2 trusts, an A Trust and a B Trust.

The B Trust, also known as the Bypass Trust or Credit Shelter Trust is filled with property from the estate up to the value of the amount of that spouse’s unused exclusion from estate taxes (for 2013, that comes to $5.25 million). Most people come nowhere near that amount, which simplifies things from an estate planning perspective somewhat, but of course, law changes could take place bringing that number down, or the rate of inflation could surge bringing people’s estates closer to that amount.

The A Trust, also known as the Marital Deduction Trust or the QTIP Trust (Qualified Terminable Interest Property), takes over the rest of the property that is in excess of the exclusion amount, deferring any taxes owed on that portion of the estate. And any CPA will tell you, a tax deferred is like a tax avoided.

Of course, under federal law and IRS rules, a spouse can give an unlimited amount to a surviving spouse outright, which is often how wills are drafted. But with a QTIP Trust, the IRS deems the property to pass to the surviving spouse even though it is in trust and eventually passes to the remainder beneficiaries, usually the children.

There are specific rules regarding the Marital Trust, not least of which is that the surviving spouse must receive the income from the trust. Other strict rules apply, so check with your estate planning attorney before attempting this.

You might be thinking, “Well, that’s all fine, but why doesn’t the first spouse to die just give all the property to the surviving spouse? That way the trusts wouldn’t be needed!” You would be right, so what’s the use? Well, especially in today’s world of blended families, husband/wife may need to provide for children from another relationship. With this type of planning, the first spouse to pass away can leave the property for the use and benefit of the surviving spouse, but the property then flows, with deferred taxes, to the children from another marriage after step-parent dies.

So, when you account for the portability of the unused exclusion amount along with an AB Trust system, taxes can be deferred greatly, but even if a couple doesn’t possess enough property at the time of the first spouse’s passing, with correct planning and solid estate management/investment strategy, the entire exclusion amount for both spouses combined (for 2013, that comes to $10.5 million) can be utilized, with planning that accounts for children from a previous relationship.

For example, say a husband and wife have created an effective AB Trust plan within their wills. Suddenly, without warning, Husband dies in 2013. He estate, after accounting for community property and any other issues, is $7 million. His estate funds the B trust with $5.25 million in property (since it’s 2013) and the rest, $1.75 million, flows into the A Trust, with the surviving Wife as beneficiary. Any taxes owing on that $1.75 are deferred until the Wife’s death.

On the other hand, assuming a couple has an AB Trust in place, but the husband’s estate is worth $4 million at the time of his death in 2013. The B trust would contain it all, the A Trust would not be funded, but the surviving wife could use the portability rules to move the $1.25 million unused exclusion amount over to herself. So, when she passes, (assuming the exclusion amounts stay at 2013 levels) she could transfer $6.5 million tax-free.

Once again, though, the beneficiary designations for trusts such as these must go along with meeting your planning goals, including handling family issues such as children from previous marriages, family strife, prodigal children, etc.

Of course, there is much more in the details of an estate plan like this, including things like generation skipping transfer tax issues depending on who the beneficiaries are, etc., which can easily be fouled up, so you should speak with your attorney about the possible use of such a plan.