New portability rules: A cure for incomplete estate planning

Many CPAs are involved in representing estates of decedents who died in 2011 and 2012. In dealing with such estates, it is important to focus on the new Code provisions allowing portability of the decedent’s unused lifetime gift and estate exclusion amount to the surviving spouse. A failure to do so can result in the loss of a significant estate and gift tax benefit for the surviving spouse that could easily be overlooked. This article focuses on the new portability election and the planning opportunities and pitfalls associated with making the election and the potential consequences of failing to do so.

To obtain the benefits of portability, estates must file Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, even if the estate’s total assets are below the $5 million (2011) or $5.12 million (2012) exclusion amount. Furthermore, the possible reduction of the federal exclusion, possibly to $1 million for decedents dying in 2013 and later, should be addressed. Executors of estates of decedents who leave a surviving spouse must be carefully counseled during the months after the decedent’s death on a number of issues involving portability.

THE PORTABILITY ELECTION

Individual taxpayers are allowed a lifetime exclusion from federal estate and gift taxes. Congress provided for a higher federal exclusion amount in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312. It also made the exclusion amount portable between spouses. These amendments, however, are to provisions of Sec. 2010 enacted by the Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16 (EGTRRA), that, as of this writing, are scheduled to expire on Dec. 31, 2012. For many years, married couples have aimed through lifetime planning to ensure the effective use of each spouse’s available lifetime exclusion from estate and gift tax. However, for a variety of reasons, this goal frequently has not been achieved. Portability gives clients a postmortem opportunity to maximize the use of each spouse’s lifetime exclusion.

LIFE PLANNING FOR SPOUSES BEFORE PORTABILITY

Before the enactment of the portability provisions, spouses who both had assets exceeding the lifetime exclusion amount would typically set up a plan requiring that, on the death of the first spouse, an amount of assets equal to the exclusion amount would pass to a “credit shelter trust” or a bypass trust for the benefit of the surviving spouse. This would preserve the benefits of the exclusions for both of them. Assets other than those passing to the credit shelter or bypass trust would pass to or for the benefit of the surviving spouse in a manner that qualified for the unlimited marital deduction from the deceased spouse’s estate. This planning allowed the full exclusion amount of both spouses to be used, resulting in a substantial reduction in the amount of estate tax paid, and through the credit shelter allowing both spouses to enjoy the benefits of their combined marital assets.

For example, assume a husband has $10 million of assets that pass under his will. If he were to die leaving all his estate assets to his surviving spouse, there would be no tax to pay in the husband’s estate, because the assets would qualify for the marital deduction. Since the $10 million would pass directly to the wife, all such assets, including appreciation, would be subject to tax in her estate. The husband would not have used any of his exclusion (assuming he made no lifetime gifts that used up any of the exclusion). In effect, his exclusion would be wasted.

FAILURE TO CREATE OR FULLY IMPLEMENT A LIFETIME PLAN

In many cases, a couple has created a lifetime plan, but not implemented it as originally projected, and the exclusion of the first spouse to die has not been fully used, thereby subjecting the survivor’s estate to an unnecessary tax.

In the example above, another way the husband’s exclusion could have remained unused was if the husband had less than the applicable exclusion amount of $5 million of assets when he died, even if his will was drafted with the exclusion portion passing to a credit shelter trust. If the husband died with $1 million of assets and the wife had $9 million, even if the husband’s will provided for a credit shelter trust, it could be funded only with the $1 million he owned, thereby wasting $4 million of his exclusion, assuming he predeceased his wife (and had not used up any of his exclusion in making lifetime gifts). A properly constructed lifetime plan would have called for the wife to make a gift (which would be tax-free, due to the gift tax marital deduction) of $4 million of her assets to the husband, so he could possess the requisite $5 million should he predecease his wife. Lifetime gifts between spouses are eligible for the marital deduction, regardless of the amount.

However, plans such as this are frequently not properly executed. The advice to make the gift may have been overlooked during the spouses’ joint lives, or the spouse with the excess assets may not have been willing to make the gift. Or the excess assets may have been retirement assets, such as IRAs, which one spouse cannot transfer to the other spouse during lifetime without triggering income tax on the transfer.

PORTABILITY UNDER THE TAX RELIEF ACT

The 2010 Tax Relief Act created the “deceased spousal unused exclusion amount” (DSUEA). For a surviving spouse, the DSUEA is the lesser of the basic exclusion amount or the basic exclusion amount of the last deceased spouse of the surviving spouse less the amount of the exclusion used by the last deceased spouse. Under Sec. 2010(c)(2), a surviving spouse’s “applicable exclusion amount” is the surviving spouse’s basic exclusion amount plus the DSUEA. As the Joint Committee on Taxation technical explanation (JCX-55-10) states, “[A]ny applicable exclusion amount that remains unused as of the death of a spouse who dies after December 31, 2010 . . . generally is available for use by the surviving spouse, as an addition to such surviving spouse’s applicable exclusion amount.” However, for the surviving spouse to get the benefit of the deceased spouse’s unused exclusion amount, the executor of the deceased spouse’s estate must make the appropriate election, as described below.

For example, in the case of the predeceased husband with only $1 million of assets, which he leaves outright to his surviving wife, his estate would have $5 million of unused exclusion, which, via the portability provision, could pass through to the surviving spouse and enable her to use the DSUEA in her estate, or during her lifetime to make lifetime gifts. Similarly, if the husband had $10 million of assets and he left them all to his surviving spouse, his unused exclusion (DSUEA) would still be $5 million (because all of the assets would be eligible for the marital deduction). Therefore, in both those situations, the surviving spouse would have her own $5 million exclusion plus the $5 million DSUEA, which would shelter $10 million from estate tax in her estate or from gift tax. Significantly, this is accomplished without the need of a credit shelter trust under the husband’s will and without having to retitle assets to assure each spouse owns at least $5 million. (However, see also “Seven Good Reasons Credit Shelter Trusts Remain Relevant,” JofA, June 2011, page 44.)

HOW THE ELECTION IS MADE

The executor of the deceased spouse makes the election by filing a “complete Form 706” within the time prescribed by law, including extensions, even if a return is not otherwise required (Notice 2011-82). As of this writing, an estate will be considered to have made the portability election by timely filing a properly prepared and complete Form 706, without the need to make an affirmative statement, check a box, or otherwise affirmatively elect on the form. The portability election is available (so far) only to estates of decedents who die in 2011 or 2012. Thus, for the election to have any benefit, unless the provision is extended, both spouses would have to die during the two-year period. Nevertheless, President Barack Obama’s administration is on record as desiring to make the portability election permanent (although it also favors reducing the exclusion amount to $3.5 million).

POSSIBLE ISSUES FOR THE ESTATE OF THE DECEASED SPOUSE

Assume the CPA is involved in the administration of the estate of a spouse who died in 2011 with assets of $1 million. No federal Form 706 return is required. Also assume this decedent died in a state where there either is no state estate tax or the state exclusion exceeds $1 million, so that no state estate tax return is required. At first blush, this might appear to be a simple estate to administer. Because of portability, however, further analysis is required.

Depending on how Congress acts, it is conceivable that portability could continue but the estate of the surviving spouse could be subject to a much lower exclusion and higher rates than the current 35% and therefore an even greater tax liability, especially if the portability election is not made. Under current law, when EGTRRA’s provisions sunset at the end of this year, the estate exclusion amount reverts to the pre-2001 $1 million and the maximum tax rate to 55%. And even if the current exclusion amount is extended (under current law adjusted annually for inflation), the surviving spouse’s assets, including any assets inherited from the first spouse and others, could increase and/or appreciate in value beyond the exclusion amount in effect at his or her death.

TIME TO FILE THE DSUEA ELECTION

Therefore, during the administration of the decedent spouse’s estate, an inquiry should be made to determine the anticipated size of the surviving spouse’s estate and whether the surviving spouse might expect an inheritance or increased assets from other sources. This inquiry should be made in sufficient time so that, if the portability election is desired, the Form 706 can be timely prepared. For estates of decedents dying after June 30, 2011, it is due nine months from the date of death, even if filed solely for purposes of making the portability election, plus a six-month automatic extension (Notice 2011-82), if the application for the extension is filed within the first nine months from the date of death.

Extension for estates of decedents dying in the first half of 2011. Many executors of estates of decedents dying in the first half of 2011 were not aware of the new portability rules and therefore may have overlooked the opportunity to elect portability by filing a Form 706 (or an application for a six-month extension to file the form) within nine months from the date of death. Recognizing this disadvantage, the IRS issued Notice 2012-21 on Feb. 17, 2012, giving estates of decedents who died between Jan. 1, 2011, and June 30, 2011, a six-month extension, until 15 months after the date of death, to file Form 706 to elect portability. This extension is available only when the gross fair market value of the estate does not exceed $5 million.

Thus, for a decedent who died on March 1, 2011, with less than $5 million, under Notice 2011-82, the executor was required to file the Form 706 or an extension by Dec. 1, 2011. Assuming the executor overlooked the opportunity and did not file a Form 706 by Dec. 1, he or she could do so anytime up to June 1, 2012. Under the Notice 2012-21 guidance, to qualify for the extension, the executor must also file a Form 4768, Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes, bearing the notation “Notice 2012-21, Extension for Good Cause Shown” or other notation that sufficiently notifies the IRS the extension is being filed pursuant to Notice 2012-21. The Form 4768 can be filed before or at the same time Form 706 is filed within the extended 15-month period. In addition if, prior to the issuance of Notice 2012-21, a return was filed after its original nine-month due date but without an extension request, an extension can be filed within the extended time frame, and the extension will relate back to the original due date of the return.

However, if the decedent died after June 30, 2011, the estate must file the return or extension application within nine months of death. Therefore, the estate of a decedent who died on July 1, 2011, must have filed the Form 706 or 4768 no later than April 1, 2012. If the decedent had died one day earlier, on June 30, 2011, the Forms 4768 and 706 may be filed by Sept. 30, 2012.

DSUEA AND LIFETIME GIFTS

In addition to the estate tax benefits the DSUEA can provide, it may also be used by the surviving spouse in making lifetime gifts. Therefore, a surviving spouse may be advised to make gifts using her own exclusion plus the DSUEA. Note that, although the surviving spouse’s exclusion is increased by inflation, the DSUEA is not. In case the DSUEA is not made permanent or the exclusion is reduced in later years, a gifting program should be considered before 2013 in which the DSUEA plus the survivor’s own $5 million exemption are combined as part of the gifting program.

Note: Some practitioners believe that a “clawback” will apply to gifts made in 2011 and 2012 if the exclusion amount falls below $5 million, as it is currently scheduled to do in 2013. Under the clawback, the donor’s estate would be taxed on the difference between the exclusion amount at the time of the gift and the exclusion amount when the donor dies. It is unclear at this point whether this potential clawback will apply.

DSUEA AND REMARRIAGE

If a surviving spouse, e.g., a widow, subsequently remarries, her applicable exclusion amount is based on her DSUEA from her first husband if she predeceases her second husband.

However, if the second husband predeceases the wife, he now becomes her most immediate predeceased spouse, and the wife’s applicable exclusion amount is based on the second husband’s DSUEA. Thus, if the second husband used all of his exclusion (even if in the form of bequests to the children of his first marriage), the wife has no DSUEA from him and cannot use the DSUEA from her first spouse as well. In such event, there should be no recapture of the DSUEA from the first husband used by the wife in her lifetime gifts, so long as she made the gifts in a year before the second spouse died. Note, however, that the IRS has not ruled on this situation and asked in Notice 2011-82 for comments on what the rules should be.

The surviving spouse should be counseled about the possible loss of a DSUEA from the estate of her first spouse if the survivor remarries. To protect against that possibility, the surviving spouse should be counseled before remarrying to enter into a prenuptial agreement that requires the second spouse to leave at least the DSUEA amount that could have been available from the survivor’s first spouse, or otherwise to provide for the survivor by planning for a credit shelter trust (or qualified terminable interest property (QTIP) trust).

STATE ESTATE TAX CONSIDERATIONS AND DSUEA

The state estate tax ramifications of electing a federal DSUEA are beyond the scope of this article. It should be noted, however, that a number of states have decoupled their exclusions from the federal exclusion. Some states require that a marital deduction by way of a QTIP election for state estate tax purposes must be consistent with the marital deduction claimed on the federal return, even if the federal return is filed solely to make a portability election (see, e.g., N.Y. TSB-M-11(9)M (7/29/11)). If a state that is decoupled from the federal exclusion requires a consistent marital deduction QTIP election on the state estate tax return, there could be a state estate tax due on the death of the first spouse. Therefore, the state ramifications of a portability election need to be considered before filing the federal return and making the election.

PLANNING STILL IMPORTANT

Portability of an unused exclusion from one spouse to the other may be considered during the planning process, while both spouses are living. A number of planning opportunities and pitfalls involving portability need to be addressed on the death of the first spouse. The failure by the executor and advisers of the first spouse’s estate to address portability might result in liability issues being raised by the survivor’s executor and heirs.

The decision of whether to file a federal estate tax return must be carefully considered. Furthermore, appropriate inquiries should be made of the surviving spouse’s assets, and he or she should be advised of the possible consequences of a remarriage. All this must be accomplished within a relatively short period after the first spouse’s death.

EXECUTIVE SUMMARY

For decedents dying in 2011 and 2012, Congress provided “portability” of the unused portion of a spouse’s lifetime gift and estate exclusion amount ($5.12 million in 2012), to be added to the exclusion amount of the surviving spouse. This “deceased spousal unused exclusion amount” (DSUEA) provision gives couples an additional way to preserve both spouses’ full exclusions, besides traditional credit shelter and bypass trusts.

However, portability must be elected by the estate of the first spouse to die, by timely filing a properly completed Form 706, United States Estate (and Generation- Skipping Transfer) Tax Return. This must be done, even though the decedent’s assets are below the exclusion amount and he or she is not otherwise required to file the return.

Form 706 is normally due within nine months of the date of death, with a six-month automatic filing extension available by filing Form 4768, Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes. For estates of decedents dying between Jan. 1, 2011, and June 30, 2011, the IRS has granted a six-month extension to file Form 706, even if the executor did not timely file a Form 4768.

Potential pitfalls of portability include that the DSUEA applies only to the most recently deceased spouse, so if a widow or widower remarries and survives the second spouse, the DSUEA of the first spouse is lost. Another planning consideration is the currently scheduled sunset of portability and the higher exclusion amount at the end of 2012. This may provide impetus for a surviving spouse to use a DSUEA in 2012 through gifting.

Jerome A. Deener (jdeener@foxrothschild.com) is a partner with the Roseland, N.J., office of Fox Rothschild LLP.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.

AICPA RESOURCES

JofA articles

• “The 10 Most Powerful Postmortem Planning Pointers for Trusts and Estates,” May 2012, page 34
• “A Sea Change for Gift and Estate Planning,” July 2011, page 24
• “Seven Good Reasons Credit Shelter Trusts Remain Relevant,” June 2011, page 44

Publications

• CPA Client Bulletin (CB_FI12, CB_FN12, CB_LN12, CB_IF12, CBDXX12, and CBEXX12)
• CPA Client Tax Letter (CTLFI12, CTLFN12, CTLLF12, CTLLN12, and CTLDXX12)
• Estate Planning After the Tax Relief and Job Creation Act of 2010: Tools, Tips, and Tactics (#091056HS, CD-ROM)

CPE self-study

• Advanced Estate Planning: Practical Strategies for Your Clients (#736982)
• Estate Planning Essentials: Tax Relief for Your Clients’ Estates (#745112)
• Form 1041: Income Taxation of Estates and Trusts (#736948)

Conferences

• National Tax Education Program, Week 3, July 9–13, St. Louis
• Advanced Estate Planning Conference, July 23–25, Las Vegas

For more information or to make a purchase or register, go to cpa2biz.com or call the Institute at 888-777-7077.

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