The estate tax laws continue their roller coaster ride in 2012 and beyond. What are the basic rules–old and new–and what can you do with them during this time of continuing uncertainty?
Some of the basic estate tax rules are the same: property still passes tax free to a U.S. citizen spouse so long as it goes outright or in certain types of trusts. Also, everyone has an exemption from the estate tax which is currently $5,120,000, but absent legislative action drops to $1,000,000 on January 1, 2013.
Given this volatile exemption pattern, one important point in estate planning is flexibility—to the extent you can, to make sure your planning fundamentally works at any exemption level.
Further, basic estate planning often takes advantage of the martial deduction to delay taxes until the death of the second of a married couple and orchestrates the passage of property to take advantage of the exemption of both spouses. Typically, that planning has been done through use of what is known as a credit shelter or bypass trust (often called a Family Trust). In other words, at the death of the first spouse property passes in a way that uses the first spouse’s exemption but is “available” to the second spouse. At the death of the second spouse her exemption can also be used. This staging effectively doubles the exemption. With this planning, under current law a couple can leave $10,240,000 without federal estate taxes.
One problem with planning to use both exemptions is that the first spouse to die has to have sufficient assets in his name to pass in a way to use his exemption. This tends to be less of a problem in community property states. Staging assets can be difficult, partly because no one knows which spouse will die first and also due to some of the income tax advantages of leaving assets to a surviving spouse. For example, it is often very advantageous to leave an IRA to a surviving spouse who can then roll it to her own IRA to delay the income tax.
A recent change in the estate tax laws does ease some of the planning for use of the exemptions of both spouses. This new feature is referred to as “portability”, and means that the first deceased spouse’s exemption can simply pass to the second spouse so long as the rules are followed and nothing disrupts that passage. In the simplest situation, under current law where a couple has, for example, $9,000,000, the first deceased spouse can leave everything to the surviving spouse, and the surviving spouse in 2012 can receive their $5,120,000 exemption which then allows the surviving spouse to pass the entire $9,000,000 to children without estate taxes. The result is excellent, but that does not mean it should be relied upon.
First, to have portability the first deceased spouse’s estate has to file an estate tax return, even if that return is otherwsi e unnecessary. For a larger estate that return is not a particular burden because it is required anyway, but in many cases that return is simply unnecessary paperwork and expense. These concerns will be even more pronounced where there is a second marriage and the surviving spouse might like to receive the exemption and the executor is a child of an earlier marriage who has no interest in the estate spending money to prepare an expensive tax return to benefit the surviving spouse. In those cases, some planning upfront to require an estate tax return— while also requiring the spouse benefiting from it to pay for it—may be appropriate.
The second problem with portability is that it can be lost. The law simply won’t let someone keep marrying and collecting exemptions and so a later marriage might use or lose the earlier exemption, making portability unavailable as originally planned. Planning for portability, where it matters, might take place as early as a prenuptial agreement in some cases.
But perhaps the biggest problem with portability is the same problem as with the estate tax itself. Current rules disappear at the end of 2012 and the law reverts to the law of 2001—long before portability was even considered. Thus, for a couple to rely fully on portability they both have to die before 2013—not exactly planning most people want.
Comparing portability to traditional planning with a credit shelter trust, portability comes up severly lacking. A credit shelter trust can be funded with the exemption at death—say $5,120,000, but the amount in the exempt trust at the second death may be significantly larger than $5,120,000, due to growth between funding and death. The exemption given through portability to the surviving spouse does not grow—but is frozen at the original amount. Also the credit shelter trust arrangement can use the generation skipping tax exemption of the first deceased spouse to save more taxes, but relying on portability can waste that first spouse’s generation skipping tax exemption.
Many estate planners guess that portability will eventually become a permanent feature in our estate tax system, though its path to permanent during the political machinations of 2012 and the post-election period are uncertain. And, relying upon portability does not maximize potential tax savings for the family.
And while for many portability may seem a nice concept and nothing to worry too much about with a $5,120,000 exemption, the exemption is scheduled to drop to $1,000,000 in 2013. While many estate planners think (hope) it will settle in higher than that, no one is confident that it will. If the exemption stays at $1,000,000 then planning to maximize all exemptions will be critical for many Americans.
For people doing estate planning, portability may be a valueable correction for mistakes, but perhaps not a core element of their planning.