When Congress resolved the fiscal cliff crisis early this year, it brought permanence to estate, gift and generation-skipping transfer tax laws that had been in flux for over a decade. In short, the American Taxpayer Relief Act of 2012 (ATRA): (1) solidified the applicable exclusion amount at $5 million (as adjusted for inflation), (2) set the transfer tax rate at 40%, and (3) made permanent certain transfer tax provisions, such as portability.
Background on Portability
Since its initial enactment in 2011, portability has received a lot of press as a method to simplify the common estate plan. Before portability, the common estate plan for a married couple with a taxable estate was to create a "credit shelter trust" at the death of the first spouse. That trust would be funded with the deceased spouse's applicable exclusion amount (also known as "exemption amount"). This planning technique sheltered the deceased spouse's exemption amount, permitting the allocated assets, including any appreciation, to escape estate tax at the surviving spouse's death. Therefore, although the credit shelter trust could be used to benefit the surviving spouse and children, its assets would never be subject to estate tax so long as the assets remained in trust.
Portability provides couples with the ability to transfer a deceased spouse's unused exclusion amount (DSUEA) to the surviving spouse. The surviving spouse may use the DSUEA to make gifts during the surviving spouse's lifetime and at death.
Example: John and Jen are a married couple with a combined estate of $7 million. John dies first, leaving all of his assets to Jen, outright and free of trust. If a portability election is made on John's estate tax return, Jen will receive his $5 million exemption. Jen will then have a $7 million estate and a combined exemption of $10 million (her own $5 million exemption and John's $5 million DSUEA), which she can apply against gifts and her estate.
The portability election is made by filing an estate tax return at the first spouse's death and is available for spouses dying after December 31, 2010. As a result, it cannot be used for a spouse who died before that date.
Planning Issues Affected by Portability
The main benefit of portability is its simplicity. Couples whose estates are valued below the combined exemption amount can direct that all assets pass to the surviving spouse. As long as the estate tax return is filed on the first spouse's death, they no longer will lose the first spouse's exemption. The surviving spouse will be able to use both exemptions.
Portability also offers potential income tax benefits. Assets included in an estate receive a new basis for capital gain tax purposes based on the value at the owner's death. In other words, if a person purchased stock for $100 and at his death it was worth $500, the stock would have a new basis of $500 for determining gain and loss.
Under portability, assets receive two basis adjustments: once at the death of the first spouse and then again at the death of the surviving spouse. Conversely, assets held in a credit shelter trust do not receive a basis adjustment at the surviving spouse's death, because they are not includible in the surviving spouse's estate. The second basis adjustment could result in significant income tax savings if the assets appreciate considerably between the death of the first spouse and surviving spouse.
It is important to note that the DSUEA will not increase for inflation. As a result, the surviving spouse's exemption and DSUEA will need to cover all appreciation of the assets if the surviving spouse wants to avoid estate tax at death.
Example: Miles and Lila, a married couple with a combined estate of $6 million, decide to use portability planning. Lila dies first and leaves her entire $3 million estate to Miles. Her executor makes a portability election, so Miles receives her $5 million exemption. Miles now has a total exemption of $10 million and an estate of $6 million. As long as Miles's estate does not increase in value to over $10 million, it will not have to pay estate tax at his death. On the other hand, if Miles lives another 30 years, it is unlikely that the combined exclusion will be sufficient to protect his estate from tax due to appreciation of his assets and no inflation adjustment of the DSUEA.
As indicated above, for the surviving spouse to acquire DSUEA, the first spouse's estate must timely file a federal estate tax return and make the portability election even if no return is otherwise required. Moreover, the IRS can challenge the reported DSUEA even after the statute of limitations has expired for the IRS to assess estate tax. Therefore, the DSUEA can be adjusted long after the initial estate tax return was filed.
Portability is not an all or nothing proposition. It may well be advantageous to leave assets to a credit shelter trust using less than the entire available exclusion, for example, to cover the applicable state estate tax exemption. The balance of the exclusion could then be left to the spouse.
A surviving spouse can only use the DSUEA of his or her last predeceased spouse. If Sarah survives a second spouse, only his exemption can be added to hers. Nevertheless, she can use the first spouse's exemption for gifts she makes before the death of her second husband.
Although the current law is considered permanent, Congress could change or eliminate portability in the future. As a result, relying solely on portability could cause adverse transfer tax consequences if the exemption decreases or portability is abolished.
Planning Issues Not Affected by Portability
Portability does provide an opportunity for couples to use both spouses' exemption without having to create a credit shelter trust. However, it does not eliminate the need for trust planning due to: (1) state estate taxes, (2) multigenerational tax planning, and (3) non-tax considerations.
- State Estate Taxes. Portability does not apply to state estate or inheritance tax in any of the 21 states and the District of Columbia that impose such tax. State estate tax is imposed on residents of jurisdictions with a state estate tax and non-residents who own real property and tangible personal property, such as automobiles and art, in these jurisdictions. The result is that the surviving spouse's estate is likely to incur a substantially greater state estate tax than when the first deceased spouse sheltered his or her exemption as with a credit shelter trust. For example, if each spouse has $5 million and one of them leaves the state exempt amount in trust or to children and the rest to the surviving spouse as opposed to leaving all of the assets to the surviving spouse, the state estate tax savings would likely vary, e.g.: New Jersey $102,600; Rhode Island $138,344; Washington, D.C., Maryland, Massachusetts and New York $151,200; Oregon $155,000; Connecticut $220,800; Maine $240,000; Delaware $363,600; Washington $365,000; Hawaii $392,000; Vermont $396,400; Illinois $470,852; and North Carolina $1,067,600. In other words, the larger the tax rate and exemption, the greater the benefit in making use of the latter in the first estate.
- Multigenerational Planning. Couples that intend to pass wealth to future generations cannot rely on portability, because the federal generation-skipping transfer tax or GST exemption is not portable. Accordingly, if more than the exemption passes to the surviving spouse who leaves more than that amount to grandchildren or the like, an additional 40% GST tax will be incurred. Wasting the GST exemption could cost the family $2.1 million at today's rates.
- Non-Tax Considerations. Although tax planning is an important component of estate planning, there are a myriad of other reasons for creating trusts.
- Blended Families. Couples may feel more comfortable with assets being held in trust in a blended family. Trust planning can prevent future conflicts in such situations as the remarriage of the surviving spouse, preservation of assets for the children of a prior marriage or the relationships among the blended family members, to name a few.
- Under-Age Beneficiaries. Many people are reluctant to leave their estates to those they consider immature financially. For them trust planning is often the answer.
- Avoiding Probate. States differ with respect to the complexity and cost associated with their probate laws. In states where court supervision is required, couples should still consider creating and funding trusts during life to avoid probate of assets that cannot be held jointly or distributed by beneficiary designations, such as certain closely held business interests.
- Substance Abuse/Disability Issues. Many times, the estate plan is created before a couple is aware of potential problems facing a beneficiary. Leaving assets outright to persons who have substance abuse issues or suffer from disabilities may be doing them a disservice. The inheritance may be used to bankroll a serious addiction, or, depending upon the disability, may prevent the beneficiary from receiving government benefits.
- Asset Protection. Trust planning offers asset protection benefits that the beneficiaries cannot create for themselves. By holding assets in trust, the trust can be used for the beneficiary's benefit while preventing the beneficiary's creditors from seizing the inheritance. Even a beneficiary who is considered financially trustworthy may have unexpected creditor issues due to an accident or divorce.
- Multigenerational planning.Often a couple wishes to keep their estate in the family. Trusts can provide that assurance.
Portability offers couples another planning option, and, depending upon the situation, may provide additional flexibility. Nevertheless, portability does not cure all estate planning ills and can be dangerous if relied upon without consultation with an estate planner.