When Your Living Trust Divides Into Three New Trusts
The ABC’s of the A-B-C Trust
In this post, I am going to discuss how a married couple’s joint living trust could be set up to get split into three new trusts upon the death of the first spouse to die. So when a married couple sets up their “avoid probate” RLT, there are both tax and non-tax factors that drive couples to set up their trust and their estate a certain way.
Non-Tax Factors
The non-tax factors (probably the most important factors) include decisions like: how do we want to leave our estate to each other; how does the estate or trust get distributed after both of us pass away; does the inheritance of any beneficiary need to be placed in a sub-trust after we die so they don’t get their inheritance in a lump sum; and who will be in charge of making sure all of this gets implemented correctly when we die as our executor and successor trustee?
Make Estate Tax Planning Fit
While I am not a big fan of having tax laws drive your major estate planning decisions (so my estate planning discussions with people usually start with something like “Let’s figure out what you want to do with your estate and then we’ll figure out how to best make that work given our current tax structure,”, it’s important though how taxes play into leaving an estate because wise estate tax planning can help you and your family preserve more and keep more in the bloodlines as opposed to leaving to the almighty federal government.
Testamentary Trusts and Sub-Trusts
Now estate planning, particularly for those who have accumulated some wealth, typically involves the creation of one or more either testamentary trusts (a trust which your will directs to be created upon your death) or one or more living trust sub-trusts (a trust which your living trust directs to be created upon the death of a married person).
Rocky and Adrian
At this point, I’m going to give you an example. So let’s make some assumptions. Let’s say Rocky and Adrian are married. Rocky’s estate is valued at $10 million. Adrian’s estate is valued at $5 million. Perhaps Rocky inherited more, or for some reason, his estate is larger than Adrian’s. And let’s say that Rocky dies in 2026 when the estate tax exemption is scheduled to be around $6 million (let’s call it a $6 million exemption in 2026 but it will likely be a bit more than that). During their lifetime, Rocky and Adrian set up their ABC Living Trust. Rocky dies in 2026 - what happens now?
The reason the Rocky and Adrian Living Trust is called an ABC Trust is because the trust instrument requires that three new sub-trusts be established upon the death of the first spouse to die. Know that estate tax planning is typically what requires the ABC Trust scenario.
The “A Trust”
So Rocky dies in 2026. We know that Rocky’s portion of their joint trust includes $10M in assets. And Adrian’s portion of their joint trust includes her $5M of assets. In an ABC Trust arrangement, the “A” Trust which gets created when Rocky dies shall include all of Adrian’s assets - her $5M. This “A” trust is also sometimes referred to as the “Survivor’s Trust” because it includes all of the assets that are attributed to the surviving spouse when the first spouse dies. So, Adrian’s $5M goes into the A Trust. The A Trust assets are not subject to the 40% estate tax when Rocky dies because they are not part of Rocky’s estate. But the A Trust assets will be part of Adrian’s taxable estate when Adrian dies.
The “B Trust”
Now we have Rocky’s $10M to deal with. So let’s talk about the B Trust. Rocky dies in 2026 with $10M in assets and a $6M estate tax exemption. So, $6M, the amount of Rocky’s unused estate tax exemption, goes into the B Trust. Rocky uses his estate tax exemption to shield the B Trust assets from estate tax. The beneficiaries of this B Trust could be Rocky’s kids, Rocky’s other desired beneficiaries; maybe income from the B Trust gets payable to Adrian after Rocky dies, maybe Adrian’s right to income and principal distributions cease if Adrian remarries. The key point here is that the B trust does not have to be set up a certain way to avoid estate tax because we are saying the Rocky’s $6M exemption shields the B Trust assets from estate tax. This B Trust is also sometimes referred to as a “By-Pass Trust” or an “Exemption Trust”, because the B Trust bypasses estate tax and because Rocky’s estate tax exemption shields this “Exemption Trust” from the 40% estate tax.
Now, so far we know that Adrian’s portion of the trust assets, which were $5M, went into the A Trust upon Rocky’s death. We also know that $6M of Rocky’s $10M went into the B Trust upon Rocky’s death, and Rocky’ estate fully utilized it’s $6M exemption to shield B Trust assets from estate tax. And note that these B Trust assets and their appreciation will not be part of Adrian’s estate when Adrian dies later. Thet B Trust assets will get a step-up in capital gains tax basis when Rocky dies, but they will not get another step-up in basis when Adrian dies.
The “C Trust”
So enter the C Trust. The C Trust is for Rocky’s assets that exceed the estate tax exemption in effect when Rocky dies. In our example, we said Rocky dies in 2026 when the exemption is $6M. But Rocky has $10M. The excess $4M goes into the C Trust. The C Trust is set up so that no estate tax is due on C Trust assets because it qualifies for QTIP Treatment or Estate Tax Marital Deduction Treatment. Qualifying for this treatment means that Rocky’s estate does not have to pay the 40% estate tax on this excess $4M, but rather those assets will be included in Adrian’s estate when she later dies. But to get this special marital deduction treatment, the provisions of the C Trust must provide that Adrian get the income from the C Trust for the rest of her lifetime, even if she remarries. This C Trust is often referred to as the “Marital Deduction Trust” or the “QTIP” Trust. And the C Trust will provide that when Adrian later dies, remaining C Trust assets revert back to Rocky’s desired beneficiaries, which I’m sure would include Rocky, Jr.
The Summary of ABC Trust Planning
So the summary of this often-confusing ABC Trust arrangement is that when Rocky dies, even though he has a large estate, no estate tax is due. Adrian stays in complete control of her share of the joint trust assets - which are now in the A Trust. The C Trust includes Rocky’s assets that are in excess of the $6M estate tax exemption - Adrian will get the income for life from the C Trust. And the B Trust assets are for Rocky’s survivors in any method he wants. When his estate tax exemption will shield these assets from the 40% estate tax, he can leave them any way he wants.
So estate tax was completely avoided when Rocky dies. When Adrian later dies, the A Trust and C Trust will be included in her estate, and the value of the A Trust and the C Trust when Adrian dies, combined with the estate tax laws at the time Adrian dies, will determine whether any of the 40% estate tax is due when Adrian later dies.
So once Rocky educated himself and finally understood these concepts, he felt compelled to sing to Adrian the famous Jackson 5 song, where Rocky sang, “ABC, it’s easy as 123, as simple as do re mi, ABC, 123 baby you and me girl.
- Have a great day!