The amount that every U.S. citizen or tax resident can gratuitously transfer during life or at death without incurring federal transfer taxes (i.e., estate and gift taxes) is $5.43 million in 2015 (assuming no prior taxable gifts). Historically, prior to 2011, this “exemption” or “exclusion” amount was a use it or lose it proposition for married couples, in that any amount not used by the first spouse to die during life or at death was not transferable to the surviving spouse for his or her later use. Thus, a marital trust (exclusively for the survivor) and a non-marital trust (for the survivor and/or the couples’ descendants) were typically established at the first spouse’s death to ensure full utilization of each spouse’s exemption, and any federal estate taxes were generally deferred until the survivor’s death.
For a married decedent dying on or after January 1, 2011, however, any unused exemption is “portable” to his or her surviving spouse. The unused amount is added to the surviving spouse’s exclusion amount and is available to the surviving spouse for subsequent lifetime or testamentary transfers. Thus, if John died in 2015 and is survived by his wife, Jane, and he had an unused exclusion amount of $5.43 million that was shown on his timely filed estate tax return, Jane’s exemption in 2015 would be $10.86 million ($5.43 million from John plus Jane’s 2015 basic exclusion of $5.43 million), assuming no prior lifetime taxable gifts by her. It's important to note that even if John's assets had a value of just $500,000, and he had passed that to Jane, the portability exemption amount would be the full amount of $5.43 million. The Internal Revenue Service issued final regulations with respect to portability in June 2015, so now is as good a time as ever to reflect on how portability fits into a married couple’s estate plan.
Tax and Non-Tax Considerations with Portability
While portability is widely considered to be a “taxpayer friendly” provision that provides flexibility, it has not abrogated the need for proper estate planning and, in fact, it has made planning more complex in many respects. Regardless of estate size, spouses should not presume that leaving everything outright to each other is adequate merely because portability may enable full use of both exemptions without the traditional marital trust/non-marital trust structure. Non-tax benefits of leaving assets in trust include: enhanced protection from the survivor’s creditors (including any subsequent spouses if there is a remarriage); protection from the survivor’s own potentially unwise financial decisions; and preservation of the distribution plan of the deceased spouse following the survivor’s death (which may be important, for example, if there is a remarriage of the survivor without a prenuptial agreement whereby a claim could be made by the survivor’s spouse under a right of election or if the deceased spouse has children from a prior marriage and wanted to make sure that the assets went to those children upon the death of the survivor).
Of course, there are also tax considerations in any estate plan, and portability has introduced more options for spouses to carefully consider and analyze. For example, if the first deceased spouse’s assets are likely to appreciate significantly after death (perhaps the survivor is much younger), the appreciation escapes estate tax at the survivor’s death to the extent the appreciated assets pass to a non-marital trust (and uses the first spouse’s exemption in lieu of portability). On the other hand, if the same assets pass to the survivor outright or in a marital trust under a portability plan, the appreciation would be subject to estate tax at the survivor’s death, but the basis of the assets would be adjusted to fair market value at the survivor’s death (therefore reducing or eliminating any income tax liability if the assets are later sold). Among other things, portability has thus shifted the focus from ensuring full use of both exemptions to planning for the anticipated estate versus income tax consequences following the second spouse’s death.
GST Exemption is Not Portable
Notably, the exemption from generation-skipping transfer (GST) taxes is not portable to the surviving spouse, unlike the estate and gift tax exemption. As a result, couples that may be hit with the GST tax on transfers or distributions to grandchildren or more remote descendants will want to make certain that they consult with a qualified estate planner to discuss their options regarding how to make use of both exclusions from the GST tax.
State Estate Taxes
Like the GST exemption, most states that have a state estate tax do not allow portability of the state exemption amount. Of the 16 jurisdictions that currently impose an estate tax in addition to the federal estate tax (Connecticut, Delaware, District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oregon, Rhode Island, Tennessee, Vermont and Washington), Hawaii is the only one that currently permits portability of the state exemption amount between spouses. A couple relying exclusively on portability of the federal exemption therefore runs the risk of being subject to higher state estate taxes if they do not develop an adequate plan in advance. It is possible to maximize the benefits of the federal and state exemptions, and thus minimize the federal and state tax burdens, through proper planning.
Tips for Portability Planning
Portability is a powerful planning tool that has increased the number of options available to married couples. Now more than ever, it is important for spouses to evaluate their existing plans and determine if they are satisfactory and as flexible as possible in the portability-era. Some final comments and observations that married taxpayers should be aware of in connection with portability include:
- The estate of the first spouse to die must file a “complete and properly prepared” federal estate tax return to elect portability of the unused exemption amount to the surviving spouse. The filing requirement applies even if the first spouse’s gross estate is below the applicable threshold amount and is not otherwise required to file the return.
- The surviving spouse is generally only entitled to the unused exemption of his or her most recently deceased spouse. Thus, a wife who receives $3 million of exemption from her deceased husband would lose the benefit of the additional exemption if she remarries and also survives her second husband (who uses his entire exclusion amount at his death). One way to ensure that the unused exemption from the first husband is not wasted would be for the wife to make lifetime gifts totaling $3 million following the first husband’s death but before the second husband dies.