In addition to extending the Bush administration tax cuts, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the "Act") signed into law by President Obama on December 17, 2010, implemented a number of changes to the federal estate, gift, and generation-skipping transfer taxes. For decedents dying in 2011 and 2012, the Act instituted a 35-percent maximum federal estate tax rate, and a $5 million federal estate tax exemption. The Act also introduced a new concept of "portability" to the estate tax exemption, giving the surviving spouse’s estate the ability to use any unused estate tax exemption remaining at the death of the first spouse—referred to as the deceased spousal unused exemption amount ("DSUEA").
Traditionally, upon the first spouse's death if assets were left outright to a surviving spouse, the DSUEA would be "wasted," because although the distributions outright to a surviving spouse upon the first spouse's death would qualify for the federal estate tax marital deduction, the assets received outright by the surviving spouse would increase the size of the surviving spouse's own estate that would be subject to federal estate tax upon the surviving spouse's death.
As a way to avoid augmenting the surviving spouse's estate, a typical estate planning technique provided that, upon the first spouse's death, assets would be divided into a marital share and a "credit shelter trust" (also known as an "A/B trust plan" or "bypass trust plan"). This estate planning concept segregated the maximum amount that could be passed free of federal estate tax—i.e., the exemption amount, upon the first spouse's death in a credit-shelter trust, and the excess over such amount either passed outright to the surviving spouse or that was held in a marital trust for the surviving spouse. The credit-shelter trust technique sheltered assets equal to the first spouse's exclusion amount from the federal estate tax both upon the first spouse's death and also upon the surviving spouse's death, as well as all appreciation on such assets during the surviving spouse's lifetime.
In contrast, by permitting portability of the DSUEA the Act would in theory avoid the need to segregate the exemption amount upon the first spouse's death in a credit-shelter trust. To illustrate the portability concept, suppose that upon the first spouse's death, only $2 million of such spouse's $5 million exemption amount was utilized, either because the first spouse's entire estate may have been only $2 million, or the first spouse's estate exceeded $2 million but the excess over $2 million comprised assets (such as retirement plans or jointly held property) that passed outright to the surviving spouse and therefore qualified for the federal estate tax marital deduction.
The Act preserves the DSUEA of $3 million by permitting portability of the DSUEA to the surviving spouse, thereby increasing the surviving spouse's total exemption amount to $8 million ($5 million of the surviving spouse’s own exemption, plus $3 million of DSUEA). Thus, no federal estate tax would be owed on the first spouse's estate, and no federal estate tax would be owed on the first $8 million of the second spouse's estate. By increasing the exclusion amount for the second spouse's estate through portability of a first spouse's unused exemption amount, the Act has created quite a stir.
However, before married couples decide to rely on the Act's new portability provisions to achieve federal estate tax savings in lieu of traditional techniques such as the credit-shelter trust, consideration should be given to several substantial drawbacks of the new portability concept:
- The portability option applies only if both married individuals die prior to December 31, 2012. Given the constant political tumult in Washington, there is no guarantee that the Act’s provisions will remain in effect into 2013 and beyond.
- Portability is not automatic. The first spouse's estate must make an affirmative election by filing a federal estate tax return, even if that spouse's estate would not otherwise have to file such a return (if, for example, the first spouse's estate was less than the $5 million federal estate tax exemption). Filing a federal estate tax return solely for the purpose of making the portability election adds an additional and not insignificant expense to the first spouse's estate administration.
- If the portability election is made on the first spouse's federal estate tax return, the statute of limitations for an audit of the first spouse's estate tax return by the Internal Revenue Service does not expire until the second spouse's death, thus potentially extending the statute of limitations for many years in the event the second spouse far outlives the first spouse. For a variety of reasons, it may be more desirable to limit the statute of limitations period for the audit of the first spouse’s federal estate tax return.
- The DSUEA applies only to the last deceased spouse. For example, suppose the husband dies and the surviving wife receives the husband's DSUEA, and then the surviving wife remarries. If the surviving wife's second husband dies before she does, the surviving wife no longer may use the DSUEA of her first husband because her first husband is no longer her "last deceased spouse."
- The Act's portability concept applies only to the unused estate tax exemption, and not to the unused generation-skipping transfer tax ("GST tax") exemption. Whereas the first spouse's GST tax exemption can be allocated to a credit-shelter trust, if portability is used, the surviving spouse can tack on the first spouse's unused federal estate tax exemption—but the first spouse's unused GST tax exemption is lost. For married couples with generation-skipping planning, the loss of the GST tax exemption could have a significant negative tax implication.
- Unlike with a credit-shelter trust, appreciation on the assets between the first spouse's death and the surviving spouse's death would not be sheltered from estate tax in the surviving spouse's estate.
- Assets held in a credit-shelter trust upon the first spouse's death are protected from the creditors of the surviving spouse, unlike assets that pass outright to the surviving spouse under the portability concept.
Although the Act's new portability concept upon first glance may seem to eliminate the need for traditional estate planning techniques such as a credit-shelter trust to maximize use of the first spouse's exemption amount, the drawbacks to such an approach upon closer examination appear to make reliance upon portability to achieve estate planning goals impractical. For those with modest estates where the portability option may be an option, the additional cost of the preparation of the federal estate tax return and extension of the statute of limitations for audit of such return may offset the benefits. Therefore, families may wish to consult with tax professionals to create an estate plan that is tailored to their needs. With the right guidance, families can create effective and long-lasting estate plans that can withstand the vagaries of life—and Congress.
However, before married couples decide to rely on the Act's new portability provisions to achieve federal estate tax savings in lieu of traditional techniques such as the credit-shelter trust, consideration should be given to several substantial drawbacks of the new portability concept.