At first glance, a new provision of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 might seem to have provided by law what estate planners have traditionally provided for their clients by setting up one or more trusts: a way to ensure that the estate or gift tax exclusion amount for the first spouse of a couple to die can be preserved and passed along to the surviving spouse. This concept, which has long been promoted as a useful tool for simplifying the estate planning of many married couples, is commonly termed “portability.”
Specifically, IRC § 2010 was amended by the Tax Relief Act to provide that in the case of estates of decedents dying and gifts made after Dec. 31, 2010, the “applicable exclusion amount” shall be equal to the sum of the “basic exclusion amount” and, in the case of a surviving spouse, the “deceased spousal unused exclusion amount” (IRC § 2010(c)(2)).
The basic exclusion amount is set at $5 million, indexed for inflation in the case of any decedent dying on or after Jan. 1, 2012.
The “deceased spousal unused exclusion amount” is the lesser of (i) the basic exclusion amount, or (ii) the excess of the basic exclusion amount of the last predeceased spouse of such surviving spouse, over the amount with respect to which the tentative tax is determined under section 2001(b)(1) on the estate of such deceased spouse (meaning the last predeceased spouse’s remaining unused exclusion amount).
However, estate planning advisers should rarely, if ever, recommend reliance upon portability. Rather, credit shelter trusts traditionally used to accomplish the same result in most cases should continue to be used in estate planning. For more on how these vehicles have been used with respect to past exclusion amounts, see “Estate Planning: Time for a Tuneup,” a JofA online exclusive article.
WHY PORTABILITY ISN’T ENOUGH
1. Portability is temporary. Section 101 of the Tax Relief Act provides that section 901 of the Economic Growth and Tax Relief Reconciliation Act of 2001 (often referred to as the “sunset” provision of the EGTRRA), is amended by striking Dec. 31, 2010, both places it appears and inserting Dec. 31, 2012. Section 304 of the Tax Relief Act provides that section 901 of the EGTRRA shall apply to the amendments made by Title III of the Tax Relief Act (which includes the portability provisions). Therefore, portability applies only in the case of a surviving spouse of a decedent dying after Dec. 31, 2010, and before Jan. 1, 2013, who also dies after Dec. 31, 2010, and before Jan. 1, 2013 (or who makes a lifetime gift in excess of his or her own remaining $5 million basic exclusion amount prior to Jan. 1, 2013).
A number of commentators have suggested the portability provisions of the Tax Relief Act are likely to be extended beyond Dec. 31, 2012. However, it is far from certain that this will happen, and well-advised clients will not base their planning upon such prognostications.
2. Only the federal exclusion is portable. Although estate planners tend to focus on the federal estate tax, it is important to remember that a significant number of states and the District of Columbia also currently impose estate taxes. Therefore, to the extent that a predeceased spouse did not use at least the portion of his or her basic exclusion amount equal to the state estate tax exemption of his or her state of residence (for example, through a credit shelter trust or some other bequest or devise other than to the surviving spouse), part or all of the deceased spouse’s state estate tax exemption will be wasted. In that event, state estate tax that could otherwise have been avoided may be due at the death of the surviving spouse.
Even individuals who live in a state that does not impose an estate tax should be concerned about this issue. First, the surviving spouse may not continue to reside in the same state. A second, and potentially more likely, concern is that state transfer tax regimes, like the federal regime, might change. For example, Illinois reinstated its estate tax effective Jan. 1, 2011, with a $2 million exemption (Illinois Public Act 96-1496); on April 30, 2010, Hawaii enacted an estate tax with a $3.5 million exemption (Act 74, Session Laws of Hawaii 2010); and on July 1, 2009, Delaware enacted an estate tax with a $3.5 million exemption (Delaware House Bill 291).
3. No indexing of deceased spousal unused exclusion amount. Although the basic exclusion amount is indexed for inflation starting next year, a deceased spousal unused exclusion amount is not. Thus, portability of the deceased spousal unused exclusion amount could be significantly less beneficial than using the deceased spouse’s unused exclusion through a credit shelter trust.
Even if the deceased spousal unused exclusion amount were indexed for inflation, its portability would likely remain significantly less beneficial than preserving it with a credit shelter trust. This is because even an inflation-indexed deceased spousal unused exclusion amount would likely garner less appreciation over time than would be the case with a credit shelter trust invested in a portfolio allocated for moderate risk.
The amount that might be sheltered through a credit shelter trust is likely to be significantly greater than the amount that might be sheltered through portability where the surviving spouse far outlives the predeceased spouse. As an example, assume that Husband dies in 2011, having made no prior taxable transfers and with a taxable estate of $5 million. Wife is the sole recipient of Husband’s estate, and an election is made on Husband’s estate tax return to permit Wife to use Husband’s deceased spousal unused exclusion amount. Let’s further assume that the new law is extended beyond 2012. If Wife were to survive Husband by 10 years, and if the $5 million from Husband’s estate were to appreciate at a relatively modest 4% compounded annually, the amount would grow to $7,401,221, obviously, well in excess of the amount that might be sheltered by a portability election.
4. Portability requires an affirmative election. Section 2010(c)(5)(A), as amended by Section 303(a) of the Tax Relief Act, provides that portability occurs only if the executor of the estate of the deceased spouse makes an election on the deceased spouse’s timely filed estate tax return. This requirement presents at least two potential problems:
First, the deceased spouse’s executor may simply fail to make a timely election, and no relief for a late election would be possible, such as under Treas. Reg. §§ 301.9100-1 through -3 (allowing the IRS discretion to grant an extension for regulatory, but not statutory, relief).
Second, the deceased spouse’s taxable estate might not be large enough to require filing a federal estate tax return. At a minimum, this is problematic because it requires the deceased spouse’s estate to incur an otherwise unnecessary cost of filing a federal estate tax return. Potentially more significant, however, is the possibility that filing a federal estate tax return will bring matters to the attention of the IRS that would have otherwise gone unreported and that have the potential to generate adverse tax consequences.
5. The GST exemption is not portable. Portability of the deceased spousal unused exclusion amount is defined by reference only to the estate tax basic exclusion; thus the corresponding generation- skipping transfer (GST) tax exemption amount, although equal to the estate tax basic exclusion (section 2631(c)), is not portable.
Thus, reliance upon portability for federal estate tax purposes could waste up to $5 million of the federal GST exemption. Any taxpayer with a large enough estate to be concerned about portability probably should also be concerned about planning for GST purposes.
6. Portability requires “privity” between spouses. “Privity” is a legal term that can be defined as “the mutual or successive relationship to the same rights of property” (Black’s Law Dictionary, 9th ed.). Portability is said to require “privity” because section 2010(c)(4)(B) provides that “the term ‘deceased spousal unused exclusion amount’ means the lesser of the basic exclusion amount, or the excess of the basic exclusion amount of the last such deceased spouse of such surviving spouse, over the amount with respect to which the tentative tax is determined under section 2001(b)(1) on the estate of such deceased spouse” (emphasis added). Thus, only the estate tax exclusion of the immediately predeceased spouse of the surviving spouse is portable.
This is, of course, significant only if the surviving spouse remarries and then survives his or her new spouse. However, in that event, the deceased spousal unused exclusion amount of the original predeceased spouse will be wasted, except to the extent that the surviving spouse used it through gifts otherwise subject to gift tax, before the death of the new spouse. This result was illustrated in a technical explanation by the Joint Committee on Taxation (report JCX-55-10), including examples in which a first husband (“Husband 1”) dies, leaving a $2 million deceased spousal unused exclusion amount, which is added to his wife’s $5 million basic exclusion amount. The wife then remarries, and the second husband (“Husband 2”), after making $4 million in taxable transfers, also predeceases her. Husband 2 leaves no taxable estate, but his estate files an estate tax return, making an election to permit the wife to use his deceased spousal unused exclusion amount ($1 million). Although both husbands’ combined unused exclusion is $3 million, only Husband 2’s $1 million unused exclusion is available to the wife, for a total applicable exclusion amount for her estate or gifts of $6 million.
7. Trusts confer benefits beyond mere transfer tax savings. Although portability can in theory provide the same federal estate tax savings, trusts confer many valuable additional benefits.
First, non-self-settled discretionary “spendthrift” trusts are an almost perfect vehicle for providing asset protection. While a surviving spouse might not have obvious significant creditor risk (for example, the surviving spouse may not be an orthopedic surgeon, real estate developer or board member of a public company), no one is completely insulated against potential creditor risk, especially anyone with substantial personal wealth. Additionally, assets can be protected from bankruptcy and divorce in a trust. With portability, on the other hand, the inherited assets are fully subject to all of the surviving spouse’s present and future creditors, as well as creditors in bankruptcy and, if the surviving spouse remarries and then divorces, to the ex-spouse.
Second, trusts can provide for professional money management and intelligent distribution of the trust fund where the surviving spouse should not be given direct control over the decedent’s property. In particular, the surviving spouse might actually be a spendthrift, might be easily influenced by third parties or, perhaps, is simply financially unsophisticated. With portability, investment management and distribution of the inherited funds is entirely within the surviving spouse’s discretion.
Third, a trust can provide for the ultimate disposition of the trust fund at the termination of the trust, which will most often be upon the death of the surviving spouse. With portability, disposition of the deceased spousal unused exclusion amount is subject to the whim of the surviving spouse. This is most often a problem where both spouses have children from prior marriages and one spouse dies. Absent a credit shelter trust, the surviving spouse could benefit her children from her prior marriage to the detriment of the decedent’s children.
WHEN PORTABILITY MAY BE USEFUL
Although attractive in concept, portability is generally not a planning tool. For at least these seven reasons, thoughtful estate planners should generally not rely on portability but should instead continue to use credit shelter trusts in connection with the estate tax exclusion of a predeceased spouse.
However, in at least three possible situations portability might be appropriate in lieu of or in addition to a credit shelter trust. Although an in-depth discussion of any of them is well beyond the scope of this article, they do at least warrant mention. First, certain assets, such as an individual retirement account, are for income tax reasons often inappropriate to leave to a credit shelter trust if they can be left outright to the surviving spouse without current or future estate tax (that is, through portability). Second, in certain estates it may be appropriate to pass only the lower state estate tax exemption amount to a credit shelter trust and to rely upon portability for the balance of the deceased spouse’s estate up to $5 million. Finally, assets held in a credit shelter trust or otherwise not included in the surviving spouse’s estate will not have their basis stepped up to fair market value at the death of the surviving spouse. Therefore, based upon a number of factors, the capital gains tax issue might indicate the use of portability in lieu of a credit shelter trust. In the final analysis, however, whether any of these three reasons is sufficiently compelling to rely upon portability rather than a credit shelter trust can be determined only on a case-by-case basis.
New provisions of the Tax Reform Act of 2010 allow a spouse to pass along any unused portion of a $5 million estate and gift tax exclusion to the surviving spouse. At first glance, this “portability” of the exclusion might seem to replace the traditional method of accomplishing the same goal by funding a credit shelter trust with an exclusion amount.
However, for at least seven reasons, credit shelter trusts still have a role in estate planning, and advisers should rarely, if ever, rely exclusively upon portability.
For one, portability is currently only a temporary provision, set to sunset at the end of 2012. For another, a number of states also impose an estate and/or gift tax.
Although the basic exclusion amount is now indexed for inflation, a “deceased spousal unused exclusion amount” is not. If the surviving spouse long outlives the other, inflation could significantly diminish the unused exclusion amount as opposed to using a trust, where trustee administration that includes sound, moderate-risk investments could significantly increase the value of assets passing free of estate tax.
An executor could fail to make the timely election required for portability, which also requires filing an estate tax return on behalf of the deceased spouse. This may otherwise be an unnecessary expense for estates below the exclusion amount. In addition, a shelter trust may still be indicated with respect to the generation-skipping transfer tax, whose exclusion amount is not portable.
Portability can be complicated by multiple marriages and can leave assets vulnerable. A trust can protect those assets from liability claims and dissipation.
Daniel S. Rubin (email@example.com) is a partner in the New York City law firm of Moses & Singer LLP.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at firstname.lastname@example.org or 919-402-4434.
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