The bill passed by Congress in January to address the so-called fiscal cliff included changes to the federal estate tax system that offer married couples new and unique planning opportunities. Not only did the law establish a higher federal estate tax exemption for every individual (currently $5,250,000 with an annual increase for inflation) but it also made it so that a surviving spouse can utilize a deceased spouse’s unused exemption through a feature known as “portability”.
Portability is not entirely new; it was created under the 2010 tax relief act, but it was made a permanent feature of our tax system under the fiscal cliff bill. When initially introduced in 2010, portability did not receive as much attention as one would expect, in large part because the IRS took considerable time in promulgating the relevant regulations, and because the whole thing was set to sunset with the rest of the “Bush Tax Cut” provisions, and related extensions and expansions at the end of 2012. Now that portability is permanent, it’s time for married couples to consider whether they may want to make changes to their estate plan to take advantage of its opportunities.
The technical details of exemption portability, especially as it relates to subsequent spouses, is beyond the scope of this article. The basic concept is that a deceased spouse’s unused federal estate tax exemption is “portable” in the sense that the surviving spouse can elect to use both exemptions at his/her later death. Before portability, married couples with assets that exceeded the current federal estate tax exemption would typically use a classic “A/B,” or marital/credit shelter, trust structure. Many couples found this approach complicated to understand and administer and contrary to their desire to own everything jointly with their spouse. One of the key purposes of such trust arrangements is to ensure that both spouses’ exemptions are maximized. This was especially the case when the exemptions were much lower than their current levels. The big question, then, is whether portability of exemption renders these split trust arrangements unnecessary. The answer is, in classic lawyer fashion, “it depends.”
One key factor is that the portability amount is not indexed to inflation (as the federal exemption currently is) and so it does not increase on an annual basis. In the case of a split trust arrangement, if the credit shelter trust assets appreciate after the first spouse’s death, they can avoid estate tax. In the same situation, if portability were elected instead, the appreciation would potentially be taxable. If there is an expectation, or a reasonable likelihood, that the credit shelter assets would appreciate and not be depleted during the surviving spouse’s lifetime, portability may not be appropriate.
However, on the other hand, the portability amount also does not decrease, even if the assets are depleted, unlike in a credit shelter trust where depleted assets translates to wasted exemption. Again, much like the prior point, the relevancy of this concern is going to largely revolve around the total asset picture involved. Wasted exclusion is a non-issue if it is not later needed at the second spouse’s death. One important note is that portability does not apply to the generation-skipping transfer (GST) tax exemption, and so if your plan involves significant gifts to grandchildren, for instance, that should be taken into consideration in your discussions with your professional advisors.
In addition to the amount of assets, the nature of those assets is also an important consideration, not just in gauging the appreciation/depletion factors discussed above, but also in assessing the potential benefit of a step-up in tax basis upon the first spouse’s death. In this sense, portability does offer the opportunity for a step-up in basis on the first spouse’s death, which may help mitigate potential capital gains tax liability down the road. A credit shelter trust does not present such an opportunity for step-up in basis. Consultation with your accountant is crucial for assessing the relevancy of this component in your own situation.
However, while portability may offer some unique opportunities for a simplified approach, it is not an automatic backstop that kicks in if/when you need it at the second spouse’s death. Rather, the portability election must be proactively made after the first spouse’s death, not the second. This requires the filing of a Form 706 after the first spouse’s death, even if no estate tax is then due. This is crucial follow-up for couples who elect the portability path. Failure to elect portability at the appropriate time could scuttle your whole plan, at least insofar as taxes are concerned.
As you can see, there are situations where portability may offer a simpler approach, and many couples tend to gravitate towards simplicity as they prepare for and enter retirement. However, as you have also seen, there are multiple potential pitfalls for going the simpler route. In addition, there are several benefits to a trust that go beyond tax planning, including spendthrift provisions that offer creditor protection, and greater control of trust management and distributions. Every family’s situation is different, and there is no one-size-fits-all approach. Talk to your legal, financial, and tax advisors to see if it makes sense for you!
Disclaimer: The THK Legal Blog is for informational purposes only and should not be relied upon as legal advice. In no case does the published material constitute an exhaustive legal study, and applicability to a particular situation depends upon investigation of specific facts. You should consult an attorney for advice regarding your individual situation.