(Please understand that the answers to these questions are general in nature and may not cover every individual situation.)
As I was finishing up law school in an Advanced Estate Planning class, I received some counsel I have never forgotten. The professor, Stan Neeleman, explained that when working up an estate plan, we should place all of the options and ideas on the board and then find the simplest way to meet the goals, as the more complex the plan the harder it is to manage. A case in point: over the past few weeks I have met with two different clients regarding the mechanisms of what’s known as an A/B trust, a widely used trust to help minimize gift and estate taxes. From 1983 to the early 2000’s a person’s estate could go to $600,000 before it was taxed. However, clever lawyers figured out a way to double that amount when a couple is involved. The mechanics work like this: We have a husband and wife getting an estate plan put together, and we decide to use an A/B trust as part of that plan. So long as both the husband and wife are alive, the trust remains revocable, which means they can change or revoke the trust anytime they wanted. However, once the first spouse died, the single trust breaks into two different trusts, one revocable and one irrevocable. An irrevocable trust is one that requires separate trustees to manage; the surviving spouse cannot get to these assets without getting the trustees’ permission. In order to get the tax benefits, one of the two trusts must be irrevocable. The purpose of having two trusts is so you can fill one up with assets to the maximum amount to avoid gift and estate taxes, and then put the rest in the other trust which can now be filled up with the remainder. It was a pretty slick way to protect $1,200,000 before gift and estate taxes applied. Congress has now raised the estate limit to approximately $5,000,000, so for obvious reasons, A/B trusts are not used as much for limiting taxes as they used to.
So, let’s go back to advising this couple. A lot of important decisions need to be made at the time they set up their trust. One such issue is “which trust shall we fill up first, the revocable or the irrevocable? Using our example above, if we fill up the revocable one first, then the surviving spouse will have $600,000 of assets totally at his or her discretion, without having to get permission from other trustees, and the remainder goes to the irrevocable trust.
However, if the estate is very large, the couple may decide to fill up the irrevocable trust first, so it will leave the larger remainder in the control of the surviving spouse. The problems I have seen lately are what happens now when this choice was made years ago. Using our example, at the time the trust was drafted, the exemption was $600,000, so the estate would fill that up first and leave the rest for the surviving spouse. So far so good. Now let’s say the first spouse, the wife, dies in 2012, after the exemption was raised to $5,000,000. Because we must fill up the irrevocable trust first, it will take the first $5,000,000 of assets before anything can go to the surviving spouse to use without having to ask the Trustee’s permission. Suddenly the clever idea of splitting the estate for tax purposes has turned into a major pain for the surviving spouse. If the entire amount of assets is less than $5,000,000, which is pretty common, the surviving husband may be left without much control at all.
This is often complicated because the survivor often doesn’t realize he needs to sit down with his accountant or lawyer when his spouse dies and decide what assets can stay out of the irrevocable trust and be put into the revocable trust, to which the survivor still has control. Often, nothing is done at the death of the first spouse and the surviving spouse does not understand what is supposed to happen. He then spends the rest of his life oblivious of the fact that according to his irrevocable trust, he no longer has the control of his assets, but spends them or gifts them to heirs anyway. Then, when he dies, the estate is a mess and often requires litigation to figure out.
There are times when the purpose of the A/B trust is to protect the assets for the heirs and not to leave all the power over the assets to the surviving spouse. In that case filling up the irrevocable trust first makes sense. But I find that most of the time the A/B it is only used for tax purposes. In that case much grief could have been avoided by funding the revocable trust first and placing only the amounts which exceed the gift and estate tax exemption into the irrevocable trust. If you are a couple with an A/B trust and are both still alive, now is the time to get with a lawyer that actually understands this stuff and see if your trust needs to be amended. If you are a lawyer who has drafted A/B trusts in the past, this would be a good time to review with the couples if, now that the exemption is over $5,000,000, they want to take another look at which trust is funded first. Either way, if your trust is more than 10 years old, you should have your estate plan reviewed.