Portability: Sharing Your Estate Tax Exemption

The last couple of years have been quite eventful for accountants and trust and estate lawyers. We began 2010 by being surprised that Congress had taken no action to address that year’s repeal of the estate tax law for decedents dying in 2010. Congress did eventually act, and on December 17, 2010, passed a tax law (“the 2010 Tax Act”) which changed the way a decedent’s estate was taxed in 2010. This left accountants and estate lawyers scrambling to try to figure out how to best advise our clients because we could “opt in” or “opt out” of applying the estate tax law and either have a step-up in tax basis or have a carry-over basis applied to the decedent’s estate.

The 2010 Tax Act also contains a provision which allows the Executor of a Deceased Spouse’s estate to elect to transfer any of the “deceased spousal unused exclusion amount” (“DSUEA”) to the estate of the Surviving Spouse, thereby increasing the amount of the exemption from estate tax available to the Surviving Spouse. “Portability”, while not specifically defined by the 2010 Tax Act, refers to this transfer of unused exemption amount from the Deceased Spouse to the Surviving Spouse. Portability benefits are only available for the estate of decedents dying in the year 2011 or the year 2012 unless Congress acts to extend this benefit.

TRUST ADMINISTRATION ISSUES

Whether or not to take advantage of the DSUEA should be analyzed on a case by case basis when administering an A-B Trust on the death of the first spouse. The Surviving Spouse must decide whether to fund a Bypass Trust without the benefit of hindsight. To make an optimal decision, the Surviving Spouse must evaluate, with his or her estate attorney the following issues: Which assets may be used to fund the Bypass Trust? What is the appreciation potential of those assets? What is the life expectancy of the Surviving Spouse? What is the likelihood that the Surviving Spouse will remarry and leave a second Surviving Spouse?

Assets held in a traditional Bypass Trust have the potential to appreciate without having that appreciation subject to estate tax upon the death of the Surviving Spouse. The valuation of those assets appraised at the Deceased Spouse’s date of death, however, sets the tax basis for the beneficiaries of the Bypass Trust when they receive those assets on the death of the Surviving Spouse. Assets in the Bypass Trust do not receive a second step-up in basis. Sale of Bypass Trust assets after the death of the Surviving Spouse may result in a capital gains tax liability to the beneficiaries of the Bypass Trust. Consideration of both the estate tax exemption and the potential capital gains tax liability is important at the death of the Deceased Spouse.

Transferring all assets to the Surviving Spouse and relying on the DSUEA to eliminate the potential estate tax liability of those assets at the Survivor’s death may make for a simplified trust administration for the Surviving Spouse. It may also provide a benefit to the beneficiaries of the Surviving Spouse because assets included in the Surviving Spouse’s estate could receive an adjustment (“step-up”) in income tax basis on the Surviving Spouse’s death. That basis adjustment would reduce or eliminate capital gains tax on the appreciation during the period between the first and second death of the spouses. Assets transferred to a Bypass Trust would not qualify for this adjustment.

BLENDED FAMILY ISSUES

In blended families, where the husband and wife each have children from a prior marriage, the decision to use the DSUEA has an impact on trust beneficiaries of both the Bypass Trust and the Survivor’s Trust. Filing an estate tax return to elect portability could provide significant savings to the Surviving Spouse’s beneficiaries because they would be able to increase the estate tax exemption available to the Surviving Spouse’s estate. On the other hand, filing an estate tax return incurs significant administrative expense for the deceased spouse’s beneficiaries.

There are also valuation issues which differ between the Surviving Spouse and the beneficiaries of the Deceased Spouse in blended families. The Surviving Spouse may want a lower valuation of assets at the death of the Deceased Spouse so that there will be more DSUEA available for his or her future estate. On the other hand, the Deceased Spouse’s beneficiaries (of the Bypass Trust) may want the assets to have a higher value in order to increase their tax basis and thereby reduce the potential capital gains liability of sale of those assets after the death of the Surviving Spouse.

REMARRIAGE ISSUES

Remarriage of the Surviving Spouse cuts off the right to use the prior spouse=s DSUEA. A Surviving Spouse who remarries will not be able to use the former spouse’s DSUEA. Only the most recent spouse’s DSUEA may be used at the Surviving Spouse’s death. Even if portability was elected at the death of the first Deceased Spouse, it is not available to the Surviving Spouse if he or she remarries.

MISCELLANEOUS ISSUES

No Inflation Adjustment. The estate tax exemption available for assets in a Surviving Spouse’s estate receive an adjustment for inflation.   But the portable portion of the predeceased spouse’s exclusion is to be frozen at the date of death value, without the benefit of inflation indexing.

Record Keeping.   A Surviving Spouse must file an estate tax return even though the size of the Deceased Spouse’s estate would not require one. The supporting documents and appraisals used for the estate tax return must be kept in the event of a future audit until after the Surviving Spouse’s death when the amount of the DSUEA and its application to the assets of the Surviving Spouse are calculated. Who should be responsible for keeping such records?

GST Tax Not Impacted. Portability is not applicable to the GST tax. The Surviving Spouse must apply the Deceased Spouse’s exemption at the death of the Deceased Spouse and any unused GST exemption is lost.

Circular 230 Disclosure, United States Treasury regulations effective June 21, 2005 require me to notify you that to the extent of this communication, or any of its attachments, contains or constitutes advice regarding any U.S. Federal tax issue, such advice is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any penalties that can be imposed by the Internal Revenue Service.