For decades, lawyers routinely recommended A/B estate plans for married couples. Many clients dutifully followed their advice, even though these plans can be convoluted. However, A/B plans that were put in place years ago could have negative tax consequences. If you haven't reviewed your estate plan recently, it might be time.
How A/B Plans Work
A key component of the A/B plan is dividing an estate into two major parts--a classic technique used by Hollywood icon Humphrey Bogart. In his will, signed eight months before he died in 1957, Bogart left all of his personal possessions to his wife, Lauren Bacall, outright. Bogart provided that after gifts to two of his servants were dispensed, half of the rest of his estate would go into a trust to benefit Bacall (Part A). Taxes would come out of the other half of the estate. Whatever remained after taxes were paid would go into a separate trust (Part B) for the couple's two children, who were young at the time. This is called a bypass, or credit-shelter, trust: Because the funds did not belong to Bacall, they would be sheltered from tax on her estate. Such arrangements were designed to preserve the first spouse's estate tax exemption, which would be lost if it wasn't used when that person died.
Portability: A Better Solution?
Tax-law changes that took effect in 2013 make another alternative more appealing for couples that are in stable first marriages and trust each other to manage their joint wealth. These couples can leave all their assets to each other directly in "I love you" wills. Then, the survivor can carry over the spouse's exemption--a process tax geeks have dubbed "portability" (http://news.morningstar.com/articlenet/article.aspx?id=686411). At 2015 rates, this system enables married couples to transfer $5.43 million apiece ($10.86 million together) tax-free. Just as under the old law, you can leave a citizen spouse or a charity an unlimited amount, without worrying about tax.
Many A/B plans are less attractive today than they once were because the federal estate tax exemption is now so large that the credit-shelter trust is not likely to save heirs any estate tax and is potentially going to cost them income tax," says Walter R. Morris, a lawyer with Wyatt Tarrant & Combs in Lexington, KY. Assets in the bypass trust are stuck with their cost basis (what the original owner paid for them) at the time they go into the trust, he explains. In contrast, assets left outright to the surviving spouse and included in her estate get an adjustment or "step-up" in basis to their value at the date of her death, which (if they've continued to appreciate) minimizes the capital gains tax heirs will eventually owe.
Some lawyers still favor bypass trusts for their nontax virtues--protecting assets from creditors, from those who prey on the elderly, and from a new spouse if a widow or widower remarries. A bypass trust can also shelter assets from state estate tax. Fourteen states and the District of Columbia impose their own estate taxes--and, in most, the exemption is less than the federal one (http://news.morningstar.com/articlenet/article.aspx?id=695676). So far, only two states (Hawaii and Delaware) have portability provisions.
But there's no consensus yet among estate-planning lawyers about the best way to address the basis problem. Ironically, most methods being discussed are even more complicated than old-style A/B planning. So, they won't appeal to clients who favor simplicity.
The Compromise Strategy: Disclaimer
Many couples with a net worth of up to $11 million can simply rely on portability, says Joshua Rubenstein, a lawyer with Katten Muchin Rosenman in New York. For maximum flexibility, though, he favors another strategy, known as "disclaimer." It works like this: You leave everything to your spouse outright, but give her the option to disclaim (or turn down) all or part of the inheritance and have it go into a bypass trust. That way, she can make an informed decision, based on her finances and the latest federal and state estate tax laws, about whether or not to use the A/B plan. "It's like playing chess with your finger still on the piece," says Rubenstein, in reference to a technique that allows you to try a move and then take it back.
Bob Simon, the CBS News correspondent who died in a car accident Feb. 11, did just that. His will, signed in 2009, left everything to his wife, Françoise, to whom he was married for 49 years, and gives her the right to disclaim all, some, or none of it into a bypass trust. Two months after he died, she disclaimed a sum described in probate court documents as the largest amount "which will pass free of federal estate tax and state estate tax in New York," after considering various deductions and credits.
Unless trust income is distributed, though, the income tax bite can be huge. That's because a trust hits the highest income tax bracket once it has more than $12,301 of taxable income. In contrast, a single individual doesn't hit this bracket until her taxable income is more than $413,200.
Options for Trustees
What can a surviving spouse do if she's stuck with a trust that's costing her more taxes than it's saving, or if she's concerned about heirs losing the basis step-up in the future? One possibility is for the trustee to distribute assets out of the trust, assuming the trust terms allow this. Bob Simon's will, for example, gives the trustee broad discretion to make payments of both income and principal from that trust to Simon's wife and other family members, as well as the power to pay out all the principal and terminate the trust.
Another option, now available in about half of all states, is for the trustee to "decant" the trust. This can involve paying out funds from one trust to another, or changing the wording of an existing trust. How much leeway the trustee has (or whether the trust can be decanted at all) depends on state law and the initial wording, says Susan T. Bart, a lawyer with Sidley Austin in Chicago. In this context, the goal would be to give the surviving spouse a general power of appointment--or the right to decide who will get the assets after he or she dies. This makes assets in the bypass trust count as part of the spouse's estate, so when she dies they get a step-up in basis.