Background to Portability. While the estate tax has been in force for many years, most estates have remained exempt from the tax due to an “applicable exclusion amount” that shelters a certain amount of a person’s assets from estate taxation (currently, $5 million). Historically, any applicable exclusion unused at death was thereafter lost. For example, if a husband and wife had “I love you” wills that left everything to the survivor of them, such a plan would not use any of the first decedent’s applicable exclusion amount (due to the marital deduction rules). At the surviving spouse’s death, only his or her own applicable exclusion amount would be available to shelter all of the assets from estate tax. Through estate tax planning, couples could create estate plans that would take advantage of the applicable exclusion amount at the first death, thus sheltering more of the assets from estate taxation at the surviving spouse’s death.
Section 303(a) of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “Act”), creates a new right of “portability” between spouses, specifically to remedy the circumstance where spouses were unable or unwilling to engage in estate tax planning. For deaths in 2011 and 2012 only, the applicable exclusion amount that remains unused at a spouse’s death (defined in the Act as the “deceased spousal unused exclusion amount” or “DSUEA”), is available for use by the surviving spouse, in addition to such surviving spouse’s own applicable exclusion amount.
Example. Husband dies in 2011 with a $5 million estate. He leaves $1 million to his children and $4 million to his spouse. Therefore, he has used $1 million of his $5 million applicable exclusion amount. If his executor elects portability, the remaining $4 million of his DSUEA can be transferred to his surviving spouse. If the surviving spouse had not otherwise used any portion of her applicable exclusion amount, then the $4 million DSUEA can be added to her $5 million applicable exclusion amount, for a sum total of $9 million that she may use for lifetime gifts or transfers at death.
While the portability rules may be helpful for estates where the decedent has otherwise done no tax planning, estate tax planning will typically be preferable to relying on portability. First, even though the estate tax exemption is portable, the generation skipping exemption is not. Therefore, clients seeking to create long-term trusts for the benefit of their children and more remote descendants cannot take advantage of portability because the first spouse’s generation skipping exemption cannot be transferred to the second spouse. Second, the portable estate tax exemption is not indexed for inflation. As a result, if the assets transferred to the surviving spouse appreciate, the appreciation will be subject to estate taxation at the surviving spouse’s death. Finally, from a non-tax perspective, assets passing directly to an individual are subject to the claims of creditors. Assets passing into a trust are generally exempt from the claims of creditors (tort or contract claims) or the claims of ex-spouses in a divorce context. For this reason, we see great utility in the continued use of trusts.
For those estates where portability is desired, there are several requirements and certain limitations in preserving the spouse’s DSUEA.
Estate Tax Return Requirement. The DSUEA is available to a surviving spouse only if an election is made by the executor of the estate of the first spouse to die on a timely filed estate tax return (Form 706). This requirement exists regardless of whether the estate of the predeceased spouse is otherwise required to file an estate tax return. This means that the executor must file a timely estate tax return even if the estate is well below the filing requirement. In 2009, only 8,238 estates exceeded $5 million, the current exclusion amount. The U.S. Center for Disease Control reported that 917,839 married individuals died in the United States in 2007 (most recent data available). Assuming a similar number of deaths of married individuals in 2011 and each successive year, nearly one million estates per year would need to file estate tax returns to elect portability, even though it is likely that less than 8,500 of these estates would exceed the filing threshold of $5 million.
The 2011 Form 706 and accompanying instructions were just released in final form on September 28th. Some suggested to Congress that the portability election might be better suited as made with the decedent’s final Form 1040 (which would be required for most decedents). These recommendations, however, have not been adopted, and an executor seeking to preserve portability will need to be prepared to file a 2011 Form 706. There is no special DSUEA election. In Notice 2011-82 released September 30th, the Service confirms that the mere process of filing the Form 706 will be sufficient to preserve any unused exclusion amount for the surviving spouse. If the executor does not wish for the surviving spouse to obtain the benefit of the DSUEA and a Form 706 is otherwise being filed, the executor will need to provide a written statement with the Form 706 that the estate is not making the election under § 2010(c)(5), or write across page 1 of the return “No Election Under Section 2010(c)(5).”
Aggregation of the DSUEA. The Act provides that portability may only occur with respect to the “last” deceased spouse of such surviving spouse. Interestingly, the insertion of the word “last” did not appear in previous portability proposals, such as H.R. 5970, the Estate and Extension of Tax Relief Act of 2006. Under prior proposals, the surviving spouse was permitted to aggregate unused exclusion amounts of several deceased spouses. As the current statute is written, however, only the last spouse’s DSUEA is portable.
Privity. There is some confusion regarding whether a privity requirement exists for use of the DSUEA amount. The Joint Committee on Taxation prepared a summary of the Act (“the 2010 JCT Report”), which contains the following example addressing portability:
Example 3 – Assume the same facts as in Example 1 and 2 [i.e., Husband 1 and Wife marry. Husband 1 dies survived by Wife. Wife marries Husband 2. Wife then dies survived by Husband 2]. Following Husband 1’s death, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1). Wife made no taxable transfers and has a taxable estate of $3 million. An election is made on Wife’s estate tax return to permit Husband 2 to use Wife’s deceased spousal unused exclusion amount, which is $4 million (Wife’s $7 million applicable exclusion amount less her $3 million taxable estate). Under the provision, Husband 2’s applicable exclusion amount is increased by $4 million, i.e., the amount of deceased spousal unused exclusion amount of Wife.
The confusion rests in the wording of new Code § 2010(c)(4), which provides that the DSUEA is limited to the lesser of:
(A) the basic exclusion amount, or
(B) the excess of: (i) the basic exclusion amount of the last deceased spouse of the surviving spouse, over (ii) the taxable estate.
Applying the statutory formula to the facts of Example 3 above, the Wife’s DSUEA would be $2 million, not $4 million. In order to reach the same results as Example 3, Code § 2010(c)(4) would need to refer to the “applicable exclusion amount” of the last deceased spouse rather than the “basic exclusion amount” of the last deceased spouse. In that case, the limitation provided in subsection (B) would be $4 million, which equals Wife’s $7 million applicable exclusion amount minus Wife’s $3 million taxable estate.
On March 23, 2011, the Joint Committee on Taxation issued an ERRATA document indicating that a technical correction may be necessary to replace the reference to the “basic exclusion amount” of the last deceased spouse of the surviving spouse with a reference to the “applicable exclusion amount” of such last deceased spouse, so that the statute reflects intent.
Fiduciary Liability for Failure to Make the DSUEA Election. Unlike most tax elections, there appears to be very little downside to a fiduciary’s preservation of the DSUEA. On the flip side, if a fiduciary fails to make an election to preserve the DSUEA, that fiduciary has created the potential for significant fiduciary liability. Not only could the liability be significant, but in most cases this would be “uncompensated” fiduciary risk (i.e., where there has been no increase in the fiduciary’s fee to compensate for this “new” risk). While portability technically expires in 2012, there seems to be support for extending its application. If so, fiduciary risk could extend many years beyond the death of the original spouse.
Example. Husband died in 2011 with a $4 million estate, $3 million of which would have been eligible for the DSUEA portability. The surviving spouse has a $2 million estate of her own at this time, but she does not want the executor to incur the additional expense of filing a Form 706. The executor follows the wife’s desires and does not file a Form 706. The DSUEA rules get extended permanently, and the wife dies in 2013 with an estate of $2 million. Assuming Congress makes no other changes to the estate tax laws, the unified credit in 2013 will be $1 million with an upper estate tax rate of 55%. Because the executor failed to make the DSUEA election at the husband’s death, the wife’s estate now faces the possibility of paying several hundred thousand dollars in estate tax that could have been avoided completely through application of the husband’s DSUEA. The husband’s executor will certainly face criticism and potential liability for failing to preserve the DSUEA at the husband’s death.
While we generally recommend preserving the DSUEA for most estates, there are certain measures available to protect against future liability for those estates where a Form 706 is not filed. One suggestion is to have the spouse enter into a release and indemnity agreement. It would serve the dual role of memorializing the spouse’s desire that the DSUEA not be preserved for his or her estate, and provide some protection to the fiduciary should there be estate tax owed by the surviving spouse’s estate. These agreements, of course, are not bulletproof. Moreover, the fiduciary should identify sufficient consideration to support the release, such as the cost savings for not filing a Form 706 that would presumably inure to the benefit of the surviving spouse if he or she were an income or principal beneficiary of the estate.
As a general matter, most estates considering portability should file a Form 4768, which automatically extends the time to file a Form 706 for six months. This will give the fiduciary the ability to make a more informed decision regarding the DSUEA should the surviving spouse die within the six-month extension period. Because Form 706 for 2011 decedents will start to be due October 3, 2011 (or properly extended by that date), fiduciaries should address this issue with surviving spouses of 2011 decedents immediately.