The Portable Estate Tax Exemption

The new tax law enacted in December 2010 raised the federal estate and gift tax exemption to $5 million and extended the “Bush tax cuts” temporarily for two years – 2011 and 2012.

Another much-touted feature of the new law is the “portability” of the federal estate tax exemption. “Portable” means easily carried or transferred, like a portable typewriter (remember those?). In this case, “portable” means easily transferred to a surviving spouse.

First, some background. Since the federal estate and gift tax gives one exemption per person, a married couple can potentially use two exemptions. The textbook estate plan for a married couple with assets over the exemption amount has been to divide assets between the spouses and for each spouse to have an estate plan which creates a trust on the first spouse’s death. The first spouse to die’s exemption is applied to the trust, by-passing the tax. The surviving spouse is the beneficiary of the trust during his or her period of survivorship. When the surviving spouse dies, he or she gets another exemption, and the assets in the by-pass trust are not taxed again. Thus, the couple has used two exemptions.

Tax policy wonks have criticized the estate tax and this planning technique, saying that it results in one system of taxation for those who consult lawyers and make estate plans with by-pass trusts, and another system of taxation for those who don’t. That’s certainly one way of looking at it. The other way of looking at it is that those who make the effort and seek appropriate advice can arrange their affairs to minimize the impact of taxes.

At any rate, the idea for portability of the exemption is that it is a way for both spouses’ exemptions to be used without separating title to assets and creating a by-pass trust. If only it were that easy.

In order to “port” a deceased spouse’s exemption to the surviving spouse, the executor of the first deceased spouse’s estate must file a federal estate tax return and make an election to allocate the unused exemption to the surviving spouse. That means that for estates of decedents dying after December 31, 2010 and until December 31, 2012, for which a federal estate tax return would normally not be filed, a federal estate tax return will now have to be filed just to “port” the exemption. Where there are separate families, there will be situations where the fiduciary who is responsible for the first dying spouse’s estate will not cooperate to make the election. Some commentators have suggested that wills (or codicils) include language to permit the surviving spouse to require the filing of an estate tax return and the filing of the election, and may require the surviving spouse to pay expenses attributable thereto.

The deceased spouse’s unused exemption amount is the “DSUEA.” Only the “last” deceased spouse counts. A surviving spouse does not lose the first deceased spouse’s DSUEA by remarrying (or remarrying and divorcing). Only when the subsequent spouse predeceases the survivor during marriage does he or she “replace” the prior spouse for purposes of determining the DSUEA available to the surviving spouse.

Even with portability, we recommend that married couples continue to structure their estate plans to take full advantage of their estate and gift tax exemptions by using “by-pass trusts” and splitting up ownership of their assets. There are several reasons for this:

● There is no guarantee that there will be a DSUEA after 2012.
● Appreciation of assets placed in the by-pass trust will escape estate taxation in the survivor’s estate.
● Creditor protection for by-pass trust beneficiaries is achieved.
● Funding of the trust helps ensure that the children of the first dying spouse have a good chance to receive an inheritance, especially if the surviving spouse remarries and is inclined to share assets with the next spouse and his or her family.
● The GST tax exemption is not portable so without a by-pass trust to which the first dying spouse’s GST exemption could be allocated, the first spouse’s GST exemption could be lost

The disadvantages of a by-pass trust are:

● There would be no further stepped-up basis on death of surviving spouse (although perhaps an unrelated trust protector could dissolve the trust for distribution to surviving spouse).
● The first estate may consist in large part of property that it is desirable to leave to the surviving spouse rather than to be put in a by-pass trust (for example, an IRA, which can be rolled over by the spouse but not the trustee of a by-pass trust).
● If the estate tax is repealed (for real), then administrative costs are wasted (accounting, income tax returns, etc.).
● Some clients think it’s too complicated to have a trust.

Portability may be causing more problems than it solves.