Portability for the Estate and Gift Tax Exclusion

April 14, 2011Articles The Legal Intelligencer

In prior articles, I discussed various provisions of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which had a wide impact on estate planning strategies. This article will focus on the new concept of "portability" contained in the act as it relates to the use of the estate and gift tax exclusion.

A basic concept in federal estate and gift tax planning is the maximization of the use of the applicable exclusion amount, which represents the amount a taxpayer can transfer to beneficiaries free of federal estate and gift tax. The amount of this exclusion has increased over the years from $600,000 in the 1980s to $5 million in 2011 and 2012 pursuant to the provisions of the act.

In addition to the applicable exclusion amount, married taxpayers can take advantage of an unlimited marital deduction so that there is no restriction on the amount that an individual can transfer, during lifetime or upon death, to the other spouse without incurring a tax. Prior to the act, any unused portion of a decedent's applicable exclusion amount would expire upon death and be of no benefit to the surviving spouse. For this reason, most estate plans for married couples with assets in excess of the applicable exclusion amount involve the use of a credit-shelter trust. A typical credit-shelter trust is structured so that the surviving spouse has limited rights of access to the trust during his or her life but the assets remaining in trust would not be subject to estate tax upon the death of the surviving spouse.

A typical estate plan in those situations would involve assets equal in value to the applicable exclusion amount passing to a credit-shelter trust with the balance of the decedent's assets passing either directly to the surviving spouse or to a marital trust for the benefit of the surviving spouse. This approach eliminates any federal estate tax through the use of both the decedent's applicable exclusion amount and the marital deduction. Absent this use of the credit-shelter trust, all of the assets of the first spouse to die would pass to the surviving spouse and be included in the taxable estate of the surviving spouse upon such spouse's death. Although the marital deduction would operate to eliminate any estate tax upon the death of the first spouse, only the applicable exclusion amount of the surviving spouse would be available to "shelter" the couple's assets upon the death of the surviving spouse. In essence, the exclusion amount of the first spouse to die would be "wasted."

To fully utilize the credit-shelter trust strategy, it is often necessary to divide marital assets so that these are assets in the name of each spouse sufficient to fully fund a credit-shelter trust without regard as to which spouse dies first.

A major change contained in the act is the amendment of Section 2010(c) of the Internal Revenue Code, which now allows for the portability of the applicable exclusion amount between spouses for decedents dying in 2011 and 2012. Under this provision, any applicable exclusion amount that remains unused as of the death of a spouse who dies after Dec. 31, 2010 (the "deceased spousal unused exclusion amount") generally is available for use by the surviving spouse as an addition to such surviving spouse's "basic" applicable exclusion amount. This provision does not allow a surviving spouse to use the unused generation skipping transfer tax exemption of a predeceased spouse.

If a surviving spouse is predeceased by more than one spouse, the amount of the deceased spousal unused exclusion amount that is available for use by such surviving spouse is limited to the lesser of $5 million (the basic exclusion amount) or the unused decreased spousal exclusion amount of the last such deceased spouse. The last deceased spouse limitation applies whether or not the last deceased spouse has any unused exclusion or the last deceased spouse's estate makes a timely election to allow the surviving spouse to utilize the deceased spousal unused exclusion amount.

A deceased spousal unused exclusion amount is available to a surviving spouse only if an election is made on a timely filed estate tax return (including extensions) of the predeceased spouse on which such amount is computed, regardless of whether the estate of the predeceased spouse otherwise is required to file an estate tax return.

The portability of the unused exemption amount between spouses and the last deceased spouse limitation can be illustrated by the following examples:

  • Example 1 — Assume that Husband 1 dies in 2011, having made taxable gifts of $3 million during his lifetime and having no taxable estate. An election is made on Husband 1's estate tax return to permit Wife to use Husband 1's deceased spousal unused exclusion amount. As of Husband 1's death, Wife has made no taxable gifts. Therefore, Wife's applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus the $2 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death.
  • Example 2 — Assume the same facts as in Example 1, except that Wife subsequently marries Husband 2. Husband 2 also predeceases wife, having made $4 million in taxable gifts during his lifetime and having no taxable estate. An election is made on Husband 2's estate tax return to permit Wife to use Husband 2's deceased spousal unused exclusion amount. Although the combined amount of unused exclusions of Husband 1 and Husband 2 is $3 million ($2 million for Husband 1 and $1 million for Husband 2), only Husband 2's $1 million unused exclusion amount is available for use by Wife, because a deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5 million) or the unused exclusion amount of the last deceased spouse of the surviving spouse (here, Husband 2's $1 million unused exclusion amount). Therefore, Wife's applicable exclusion amount is $6 million (her $5 million basic exclusion amount plus $1 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death.

Amended Code Section 2010(c)(5)(B) provides that notwithstanding the regular three-year statute of limitations for assessing estate or gift tax with respect to a predeceased spouse, the IRS is now authorized to examine the return of a predeceased spouse for purposes of determining the correct calculation of the deceased spousal unused exclusion amount available for use by the surviving spouse. The secretary of the Treasury is directed under the act to prescribe regulations as may be appropriate and necessary to carry out these rules.

While the concept of portability is appealing since it could make estate planning for married couples less complicated, its use and practice will likely be anything but simple. Many factors will be involved in deciding whether to take advantage of portability, including the following:

  • Portability is currently in the law only for 2011 and 2012. Not knowing whether portability will remain in 2013 or beyond, it would be very risky not to re-title assets and not to plan for the use of a credit-shelter trust as a "fail safe" planning technique.
  • Because the statute of limitations for the first spouse's estate tax return is extended for purposes of calculating the deceased spousal unused exclusion amount, it may be prudent in certain situations not to elect portability and to start the statute of limitations running. This is especially true if there are difficult to value assets and it is important to avoid the IRS having a second chance to challenge asset values.
  • Portability only applies to the last deceased spouse's unused exemption. If the surviving spouse remarries and survives the second spouse, the first deceased spousal unused exclusion amount will be lost. This may become a factor in certain remarriage situations.
  • There are also income tax basis issues to consider. With portability, the tax basis of the assets of the first spouse to die will have two opportunities to be stepped-up to fair market value; upon the death of the first spouse and again upon the death of the second spouse. For assets passing to a credit-shelter trust, there is a single step-up in basis upon the death of the first spouse. The assets in the credit-shelter trust will not get a second step-up upon the death of the second spouse or upon the termination of the trust. In essence, portability may reduce capital gains taxes in the case of appreciating assets.
  • For assets that have the potential for significant future appreciation, a credit-shelter trust may still be a good planning technique since the assets passing to a credit-shelter trust will by-pass inclusion in the estate of the surviving spouse.
  • There are many reasons to use trusts aside from potential estate tax savings. These include asset protection, professional asset management and protection of assets where there have been multiple marriages and the surviving spouse is not the parent of the deceased spouse's children. Trusts can help in all of these situations and the reasons for establishing a trust may outweigh the simplicity of portability.

Although portability will greatly simplify the estate plan of many married couples, this provision of the act is fraught with many uncertainties, including whether portability will remain in the Tax Code beyond 2012. Careful consideration should be given to all existing estate plans to determine if the simplicity of portability outweighs the benefits of using more traditional trust techniques.

"Reprinted with permission from the April 14 issue of The Legal Intelligencer. (c) 2011 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved."