CalEstatePlanning

This page mainly discusses estate taxes and the differences between the older style of "A-B" or "bypass" trusts for couples, and the newer, more flexible "disclaimer" trusts. References to “married couples” in this article include registered domestic partners (RDPs) as well as spouses with marriages recognized by the State of California. For a more general introduction to revocable living trusts and some trust tax planning issues, see our "Trusts vs. Wills" page.

The “A-B” trusts that some couples still have were developed in the 1980s and ‘90s with an overriding focus on reducing estate tax by dividing marital assets between (or among) separately taxable sub-trusts as of the first spouse’s death.

Over the past few decades, Congress has increased the estate and gift tax threshold — that is, the total value of assets that must be reached before gifts and inheritances to others are taxed — from $625,000 in 2001 to $13.61 million for each U.S. citizen who dies in 2024. (For recent year-by-year estate tax rates, see the IRS reference pages. For historical perspective, see the table of thresholds and rates from 1916 to 2007 in the IRS article, “The Estate Tax: Ninety Years and Counting.”)

If the combined value of a deceased U.S. citizen’s assets at death, plus the reportable gifts they made during life, does not reach the estate and gift tax threshold amount, then estate and gift tax is unlikely to apply. (Meanwhile other taxes such as income tax and property tax may apply, and capital gains tax may be an issue for heirs reselling assets.)

Because the current threshold is so high, estate and gift tax currently applies only to cases of exceptional wealth. The vast majority of U.S. deaths in 2021 will not result in estate tax unless the law changes drastically by year’s end.

While the threshold remains high, the “A-B” mechanism is unhelpful to most surviving spouses — and meanwhile it has disadvantages involving limits on surviving spouses’ control over assets. Some have petitioned courts to recombine “A-B” subtrusts into single trust entities.

Since the 2020 elections, however, there have been renewed proposals to lower the estate and gift tax threshold, so the old mechanisms may become useful again to more households.

As a result, couples who still have A-B trusts may wish to consider having their trust changed to a disclaimer trust, or revising the bypass trust for greater flexibility. As explained further below, disclaimer trusts allow the surviving spouse to choose whether to keep all of the trust assets together in one revocable trust entity, or whether to “disclaim” some of the assets so that they flow into a second irrevocable trust, with a result similar to the old “A-B” mechanism.

How A-B Trusts and Disclaimer Trusts Work

A-B trusts and disclaimer trusts both start out the same way and have the same basic functions. They are simple family trusts for married couples who have assets and finances that were typical of the U.S. middle class in the late 20th century – for example, with a paid-off family house, pensions, and some savings and investments. While both spouses are living, the trust remains revocable, which means the assets are taxed on the spouses’ Social Security numbers and the spouses are free to amend or revoke the trust any time if they agree to do so.

The main difference between A-B trusts and disclaimer trusts is in who decides what happens after the death of the first spouse, and what has to happen to lock in that decision as irrevocable.

The A-B Trust approach

Typically, when the members of a married couple create an A-B trust, they agree in advance on what will happen at the first spouse’s death. Both spouses serve as trustees so long as they are alive and able to make financial decisions. They agree that, when either one of them dies, the trustee (usually the surviving spouse) must follow a mandatory requirement to divide the household assets into two or more separately taxable subtrusts. Very often the requirement is to divide the assets evenly and place half the value into a revocable “survivor’s trust” or “Trust A” and the other half into an irrevocable “bypass trust” or “Trust B.”

This division serves the main estate tax planning goal: because each subtrust contains only a fraction of the total family assets, it is less likely to reach the estate tax threshold than a single trust containing all the assets.

Under this old model, the revocable survivor’s trust holds the surviving spouse’s share of the couple’s assets. The surviving spouse (the “survivor”) has full control over the portion of the assets that are in this subtrust, and they are still taxable on the survivor’s Social Security Number.

However, the same is not true for the bypass trust, which is the irrevocable subtrust made to hold the deceased spouse’s part of the household assets. If the bypass trust has income, it is taxed separately under its own federal tax ID number. (Sometimes this trust doesn’t have income for a long while, as when the asset placed into it is an ownership interest in a family house where no one pays rent.) The surviving spouse generally receives income from the bypass trust and has access to its principal in emergencies. However, the bypass trust functions mainly as a container to preserve and manage assets during the survivor’s lifetime, after which those assets can be given to the beneficiaries of the deceased spouse – typically, the couple’s children.

(An irrevocable subtrust of this type may also be called a “credit shelter trust”, “credit shelter exemption trust”, “exemption trust”, “credit trust”, or “nonmarital trust”.)

Under the A-B model, the members of the married couple agree to all these decisions when they sign their trust together, often many years in advance. The couple can change their trust by amendment as long as they are both living, if both are mentally able to make financial decisions – or if a spouse who cannot make financial decisions is represented by an agent who is empowered to change trusts under a durable power of attorney, and the phrasing of the trust does not prevent it.

If the spouses do not change their A-B trust before the first death, the surviving spouse can still change the survivor’s trust with respect to half the assets – but the half of the assets that must go into the irrevocable bypass trust cannot be transferred or spent contrary to the trust requirements.

With these restrictions it may be more difficult for the surviving spouse to maintain a comfortable standard of living. Often more important, it can be practically awkward to manage assets that are divided between two trusts – especially if the equity in the family house had to be split between the two subtrusts to comply with trust requirements to divide the assets equally. For example, if the surviving spouse wants to sell the existing house to move to a smaller living space and pay increased living expenses, that choice may be hampered by the rules of the bypass trust.

Sometimes a court is willing to grant a petition to change the irrevocable trust to fit changed circumstances, especially if the change is a reasonable family goal agreed on by the affected survivor and all beneficiaries. But success is not guaranteed, and it’s better to plan in advance to avoid having to go to court in this way.

Because A-B trusts lock in decisions that both spouses have reached together during life, they may be appropriate where spouses have less than complete confidence in each other’s future decisions, or in situations such as second marriages where each spouse wants to make a definite advance commitment to their own side of the family.

These restrictions in A-B trusts are often heavier than quite necessary to reduce the risk of estate tax. Looking back, it seems possible they went unquestioned for many years because of quiet continuing reluctance to trust widowed women with control of family finances.

The disclaimer trust approach

Disclaimer trusts do not force the surviving spouse to split the estate when one spouse passes away. In contrast to A-B or bypass trusts, disclaimer trusts give the surviving spouse a choice, during the nine months following the deceased spouse’s death, to keep the trust as a unified whole if there is no tax reason to divide it – or to split off any percentage the surviving spouse chooses into an irrevocable “disclaimer trust” that functions like an A-B “bypass trust”.

Disclaimer trusts offer maximum flexibility where there is substantial trust between spouses, and each spouse wants the other to keep and use the household's combined property after the first spouse passes away.

Since times and legislatures change, the flexibility is important. For all we know, some future Congress may lower the estate tax threshold again. Or the California Legislature may renew a proposal from past years to reinstate the California estate tax with a $3.5 million threshold. If estate tax again becomes a factor in planning for more Californians, for these or other reasons, a surviving spouse following the death of a deceased spouse could still exercise the disclaimer option to suit the circumstances at the time.

A disclaimer trust does require a high degree of trust between spouses because it gives the surviving spouse full control over both spouses’ assets after the first death, including the right to change the estate plan entirely. In other words, the disclaimer trust does not guarantee any share of the estate to the deceased spouse’s heirs or named beneficiaries. However, if both spouses trust that each will not disinherit the other’s heirs or beneficiaries, then the disclaimer trust is an attractive alternative to the bypass trust.

Couples should also consider that the disclaimer trust form requires relatively quick action from the surviving spouse, which can be difficult during the grief process. If the disclaimer trust is to be funded at all, the survivor must take care of the necessary decisions and paperwork within nine months after the first spouse passes away.

For those fortunate enough to worry about estate tax

The $13.61 million applicable exclusion amount in 2024 is of particular importance for members of married couples. For a married couple, if both are U.S. citizens, there is generally no immediately payable tax upon the death of the first spouse, to the extent the first spouse leaves property to the surviving spouse. However, when the surviving spouse also dies, if the surviving spouse’s estate contains more than the estate tax applicable exclusion amount, then federal taxes of up to 45% may apply to assets above the exclusion amount.

Although the surviving spouse may be protected against an immediate tax at the time of the first death, couples who did not take care of estate planning before the first death can lose the advantage of the first spouse’s $13.61 million exemption, with consequences that are postponed until after the second death. The unlimited marital deduction allows U.S. citizen spouses to pass unlimited assets to each other upon death, without taxes. However, if one spouse dies without advance estate planning, the couple has lost the use of that spouse’s estate tax applicable exclusion amount. That missed opportunity can leave the surviving spouse with a too-large estate resulting in an unnecessarily high tax on the estate when it passes to the couple’s heirs.

If a married couple together have assets that exceed the current year’s estate tax amount ($13.61 million in 2024) they still may be able to reduce federal estate taxes by creating a living trust that divides their assets into separately taxable sub-trusts after the first death of a spouse. The purpose of the division is to allow each spouse’s $13.61 million allowance to apply separately so that estate tax does not apply until double that amount has been reached.

The choice of a bypass trust would make effective but inflexible use of the $13.61 million federal estate tax exemption of the first spouse to die. A disclaimer trust could have a similar effect, but the surviving spouse would be able to decide, after the deceased spouse’s death, how much of the main trust assets to set aside in the disclaimer trust, depending on appropriate tax advice at the time of the decision.

Without a trust that shares and divides assets along these lines, the couple would lose the advantage of the decedent’s $13.61 million estate tax applicable exclusion amount.

Examples of tax planning during life for married people

Here are some examples of the estate planning concepts discussed above, involving hypothetical situations (no references to real people are intended):

Gift tax examples

Under federal combined estate and gift taxation, each U.S. citizen individual (and some non-citizens, but check rules) is subject to a lifetime limit on the combined value of reportable gifts made during life plus the value of assets left for others at death. Currently that lifetime limit is very high — $13.61 million in 2024 — but there are frequent discussions of whether Congress will lower the limit. Gifts that exceed $18,000 (as of 2024) per donor, per person, per year must be reported to the IRS on a Form 709 gift tax return. A filing of this type often doesn’t lead to an immediate tax bill, because most people never have $13.61 million to give away. However, gifts above $16,000 per donor, per recipient, per year, begin to eat into the lifetime gift tax exemption. Any gift exceeding the limit counts against the donor’s allowance of gifts and bequests that may be made before estate tax applies. A large gift or bequest made in 2024 falls under the current $13.61 million estate and gift tax threshold. If Congress does not change the law, thresholds are scheduled to increase each year through 2025 and then they are scheduled to drop to 2018 levels.

Example 1: Yearly gifts without attention to gift tax planning

If a parent gave a child $25,000 each year in 2019, 2020, and 2021, when the annual gift exclusion amount, per donor, per donee, was $15,000, the parent would have been required to file a gift tax return for each year’s gifts, and the parent’s lifetime exclusion amount would have been reduced by each $10,000 amount beyond each year’s $15,000 exemption. Therefore if the parent died before the end of 2021, the IRS would add the three $10,000 amounts from the gift tax reports, or $30,000 altogether, to the parent’s total assets at death, and will impose tax if they add up to more than the threshold amount that determines where estate tax begins to apply. The same rule would apply if a parent gave a child $26,000 in 2024, now that the exclusion amount is $18,000 per donor, per donee.

Example 2: Yearly gifts according to a gift tax strategy

On the other hand, if each of two parents separately gave $12,500 to the same child in each of 2019, 2020 and 2021, they would have had no obligation to file a gift tax return for that action, and if a parent died in 2021, the deceased parent’s lifetime exclusion amount would not be reduced by the history of gifts at or below the threshold of $15,000 per person per year.

Bypass trust examples

These examples show how bypass trusts can help married couples, but also how they can interfere with surviving spouses’ access to their savings.

Example 1: An old “A-B” trust restricts the survivor unnecessarily -- $1 million estate

Bill and Jane have personal property, savings and investments worth $300,000 and a house worth $700,000. Together they add up to $1 million worth of community property assets. Their bypass trust, written in 1990, provides that at the first spouse’s death, the survivor must place half the estate into a revocable survivor’s trust and half into an irrevocable bypass trust. Bill dies in 2017, when the estate tax threshold is $5.49 million. Although their total assets are nowhere near as high as the estate tax threshold, the bypass trust still requires Jane to divide the family assets in half.

Jane is allowed to make a “non pro rata” division of assets, so she places all of the savings accounts, personal property, etc. into the survivor’s trust that is under her control, and then she executes a house deed transferring $200,000 worth of equity to the survivor’s trust and $500,000 worth of equity to the bypass trust. The bypass trust doesn’t take any extra administration while she lives in the house, and it doesn’t limit her ability to manage the house or install a new roof when it’s needed. However, because of a medical condition she needs help from a home care worker for several months, and she has trouble paying that increased expense because the divided ownership makes it difficult to borrow against the house. She also would prefer to sell the house and move to a smaller condo near her grandchildren, and the bypass trust makes that more difficult.

Example 2: Successful use of a bypass trust to reduce federal estate tax -- $7 million estate

Now, suppose Bill and Jane made a fortunate investment and, as of Bill’s death in 2017, they have $7 million. Jane follows the instructions in the 1990 bypass trust and they work out well for her: She divides the assets in half, so that $3.5 million funds the bypass trust for Bill’s heirs and $3.5 million goes to a “survivor’s trust” for Jane. Jane is free to use the $3.5 million in her survivor’s trust as she pleases, and it is more than enough to handle the move to be near the grandchildren. Jane receives the income from Bill’s bypass trust, but she will have limited access to the principal in the bypass trust.

The following diagram illustrates the split in trust funds:

$7 million
↓
$3.5 million irrevocable bypass trust for deceased spouse (Bill)
$3.5 million survivor's trust for surviving spouse (Jane)
If Jane dies in 2020, Jane’s heirs inherit the $3.5 million in Jane’s survivor’s trust, while Bill’s heirs inherit the $3.5 million in Bill’s bypass trust. No federal estate tax is due.

Example 3: The Flexibility of a Disclaimer Trust -- $1 million estate

Returning to Bill and Jane and their $1 million community property estate, let’s again assume Bill passed away in 2017, but the couple had their 1990 A-B trust restated as a disclaimer trust in 2010. Bill left his share of the estate to Jane. The applicable exclusion amount in 2017 is $5.49 million. No tax is due at Bill’s death because of the unlimited marital deduction. Jane chooses not to fund the disclaimer trust because she believes Congress will not reduce the applicable exclusion amount enough to matter for her asset level. If the exclusion amount does not fall before Jane's death, her estate will pay no federal tax. Jane is able to borrow against the house to pay the caregiver during her illness and later sells the house to move to a condo near the grandchildren, who live in a less expensive city.

Example 4: The Flexibility of a Disclaimer Trust -- $7 million estate

On the other hand, suppose Bill and Jane have a $7 million estate and their trust was redrafted in 2010 as a disclaimer trust. Bill dies in 2017. The trust allows Jane to make use of the federal tax rule that she may “disclaim” assets at any time within nine months after Bill’s death. She disclaims $2 million out of the $7 million estate, using the option in the trust document to create a "disclaimer trust" with those assets. Her access to this $2 million will be very restricted under the terms of the disclaimer trust, but the other $5 million will be in a survivor's trust that she controls fully, and it will provide amply for her own needs. Meanwhile the $2 million is set aside for her heirs with a lower risk of estate tax. If Bill had died in 2024 instead of 2017, the estate tax threshold would have been $13.61 million instead, so when Jane made her disclaimer decision, she would likely not have chosen to divide even this very large trust estate at all.