9125 / How can an A-B trust be used by individuals in a blended family to plan for inheritances by children from prior marriages?

In order to accomplish this, many individuals use trusts in order to ensure that a surviving spouse has sufficient income for life, but that the first-to-die spouse’s assets ultimately pass to his or her biological children (rather than to any stepchildren or future spouses of the surviving spouse). Creating what is known as an “A-B trust” (also known as a bypass trust, which were typically created to avoid estate taxes prior to the increase of the federal estate tax exemption and introduction of portability, see Q 9122) can ensure that both the spouse and decedent’s children benefit from a decedent’s estate according to his or her wishes.

The A-B trust can really take many forms, depending upon the parties’ wishes. For example, the decedent can leave a portion of his or her estate in the “A trust”, typically a revocable grantor trust that gives the surviving spouse use of the trust income for life, but often leaves the remainder (trust principal) to the decedent’s children. The “B trust” is an irrevocable trust that would contain a portion of the decedent’s estate to either immediately benefit his or her own children, or to provide income to the surviving spouse with the trust principal preserved for the children (depending upon the wishes of the decedent).

While the surviving spouse may have the ability to modify the beneficiaries of the A trust and retain some control over the principal of that trust (depending upon trust terms), the B trust is irrevocable. In this manner, both the surviving spouse and decedent’s children are protected. Further, the client has ensured that at least a portion of his or her assets will ultimately pass to his or her own children, rather than to stepchildren or as the surviving spouse directs.

This type of trust structure also helps very wealthy families minimize estate taxes. The portion of the trust that does not pass unfettered to the surviving spouse is funded with an amount equal to the federal exemption amount to shield those assets from estate taxes, while the “marital” portion of the trust can be funded with whatever amount of assets the first-to-die spouse wishes (and will be sheltered from estate tax by the marital deduction).

In these scenarios, the A trust is typically established as a grantor trust, which is taxed to the individual grantor. The B trust is irrevocable, so is taxed according to general trust rules and must file a Form 1041. Because the B trust is irrevocable, it could also potentially be used to protect the assets of the first-to-die spouse from a financially irresponsible surviving spouse (i.e., from the surviving spouse’s creditors, see Q 9074 to Q 9088 for a discussion of asset protection trusts).

See Q 9123 to Q 9124 for a discussion of qualified terminable interest property (QTIP) trusts, which are another option that can be useful in the blended family context.