Estate planning is analogous to building a handmade mechanical clock. A wise attorney considers the many “moving parts” it takes to realize a client’s estate planning goals and all that is needed to make a plan come together like “clockwork.” The American Taxpayer Relief Act of 2012 or “ATRA” is a law that impacts estate planning and may affect how you plan for your future. In this article, I cover the significance of this law and what it means for you.
According to federal estate tax law, each person has a lifetime federal estate tax exemption. In 2016 this amount is $5,450,000.00. This means, a person may pass or “port” property valued up to $5.45 million without paying any federal estate or gift tax.
WHAT IS PORTABILITY?
Portability of the federal estate tax exemption between married couples means that when the first spouse dies the amount of the exemption that was not used for the deceased spouse’s estate may be transferred or “ported” to the surviving spouse who can then use it for his or her own estate tax purposes.
What does portability allow?
Portability allows the personal representative(the executor or administrator of the estate of a deceased spouse) to make an election on the deceased spouse’s estate tax return to transfer or “port” the deceased spouse’s unused exclusion amount (sometimes the “DSUE amount”) to the surviving spouse.
Note: In many states, there are state estate taxes to contend with which are not affected by ATRA.
Before portability, each spouse was forced to use his or her lifetime exclusion either before death (by gifting for example) or at the time of his death. If the lifetime exclusion was not used, it was lost. Thus, the lifetime exemption was a “use-it-or-lose-it” proposition.
WHAT DOES PORTABILITY ALLOW?
With portability, a couple is not limited to consuming the first spouse’s lifetime exclusion at death. Instead, portability extends the time to use both spouses’ exclusion until the surviving spouse dies. This expansion of time changes the estate planning game. In certain cases, this time expansion could lead to advantageous planning for couples. Planning is important!
Before portability, married couples had to divide and re-title ownership of their assets between them so that each had about the same level of net worth. Their will (or revocable trust document) also had to establish a trust on the death of the first spouse in the amount of the estate tax exclusion. The “credit shelter trust” is sometimes called a “bypass trust” because it bypasses the taxable estate of the surviving spouse.
Historically, when considering a plan for spouses, the estate planner would use either a “credit shelter” or “bypass” type trust in order to utilize the exemptions of each spouse. This credit shelter type trust can:
- allow the survivor to be sole trustee;
- grant the survivor the right to all income;
- grant the surviving spouse the right to principal for “health, maintenance and support in reasonable comfort” (the so called “Ascertainable Standard”); and
- grant the surviving spouse a right to withdraw the greater of 5% or $5,000.00.
(Sometimes, “powers of appointment” were granted as well, but this topic is beyond the scope of this article.)
Notwithstanding all of these powers, the trust was not “included” in the taxable estate of the survivor thus generating tax savings by “sheltering” the credit (or the exemption amount) of the first spouse to die. In other words, if the exemption of one spouse is “sheltered” by the trust, the survivor’s exemption is available to shelter additional assets from the estate tax. The trust could have been drafted with fewer powers and rights depending on the family situation. The assets passing into the trust would not be adjusted up or “stepped up” at the death of the survivor. A “step up” in basis means readjusting the value of an inherited asset to be the higher of the market value at the date of death or the purchase price. However, with portability, there is the advantage of a second step up in basis on the death of the second spouse to die. The step up in basis with portability avoids capital gains taxes on resale of the asset upon the death of the surviving spouse; with a bypass trust, there is only one step up in basis.
The advent of portability, allowing the carryover of the deceased spouse’s unused exemption (“DSUE”) has sometimes changed the bypass or credit shelter trust approach in many jurisdictions, but not all.
EXAMPLES OF THE ESTATE TAX EFFECT
Result Without the Use of Portability
Bob and Sue are married and have all of their assets jointly titled and their net worth is $8 million. Bob dies first in 2016. The federal estate tax exemption is $5.45 million on the date of his death. Assume that the portability of the estate tax exemption between spouses is either not in effect or not elected timely. Under these facts:
- Bob’s estate will not use any of his $5.45 million estate tax exemption. The “unlimited marital deduction,” a tax rule that allows money to be passed between spouses without triggering a taxable event, will be in effect. This allows Bob’s share of the joint assets to be automatically transferred to Sue by right of survivorship without incurring any federal estate taxes.
- Later, Sue dies. The federal estate tax exemption is still $5.45 million and the estate tax rate is 40%. Sue’s estate is worth $8 million.
- With Bob’s $5.45 million estate tax exemption wasted, Sue can only pass along $5.45 million free from federal estate taxes. Thus Sue’s estate will owe about $1 million in estate taxes after her death: $8,000,000.00 estate minus the $5,450,000.00 exemption equals $2,550,000.00. The $2,550,000.00 taxable estate times 40% estate tax results in $1,020,000.00 in taxes will be due.
Result with Portability
Assume Bob and Sue are married and have all their assets jointly titled and their net worth is $8,000,000.00. Bob dies first in 2016 and the federal estate tax exemption is $5,450,000.00 on the date of Bob’s death. Assume that portability of the estate tax exemption between spouses is in effect.
- As above, when Bob dies, his estate will not need to use any of the $5,450,000.00 estate tax exemption since all the assets are jointly titled and the “unlimited marital deduction” allows for the automatic transfer of Bob’s share of the joint assets to Sue by right of survivorship or by tenancy of the entireties and without incurring any federal estate taxes.
- Assume that at the time of Sue’s later death, the federal estate tax exemption is still $5.45 million, the estate tax rate is 40% and Sue’s estate is still worth $8,000,000.00.
- Enter portability of the estate tax exemption. Using the concept of portability of the estate tax exemption between spouses, under these facts, Bob’s unused $5,450,000.00 estate tax exemption will be added to Sue’s $5,450,000.00 estate tax exemption, in turn giving Sue a $10,900,000.00 exemption.
- Since Sue has “inherited or ported” Bob’s unused estate tax exemption, and she can pass along $10,900,000.00 free from federal estate taxes at the time of her death, Sue’s $8,000,000.00 estate will not owe any federal estate taxes at all.
- Thus portability of the estate tax exemption will save the heirs of Bob and Sue about $2,900,000.00 in estate taxes.
- Note that Sue will not automatically “inherit” or “port” Bob’s unused exemption. Sue must timely file IRS form 706, United States Estate and Generation Skipping Transfer tax return, in order to make an affirmative election to add Bob’s unused exemption to Sue’s exemption.
Portability has limitations. Do you still need a bypass trust given portability? Possibly. Pre-portability one of the main reasons for a bypass trust was to take full advantage of the lifetime exemption while providing for your surviving spouse. Unless your estate is likely to be more than $10,900,000.00, you do not need a bypass trust to save the exemption. However, there are other reasons a bypass trust can still be an important part of an estate plan.
- Creditor Protection. Trusts can protect assets from creditors of your loved ones. Creditors can include ex-spouses, winners of lawsuits and business partners. Creditors may include lenders and credit card companies. If one of your loved ones has financial problems or a rocky marriage, or is in a line of work that risks lawsuits, consider leaving at least part of your estate in a bypass trust so that it eventually benefits your chosen beneficiaries.
- Preserving Your Intentions. You want to provide for your spouse for the rest of his or her life, but you may also want to ensure that whatever is left of the estate goes to those whom you want eventually to receive it. Some people are concerned a spouse might remarry and leave the money to the new spouse and perhaps a new family. Others already in second marriages are not always confident that the surviving spouse will leave any of the estate to the children of the first marriage. There are many other reasons why your surviving spouse might not carry through on your intentions and those are reasons to consider having a bypass trust.
- Preparing for Growth. The estate tax is imposed on the value of assets at the time of the owner’s death. Maybe your joint estate is worth less than $10,500,000.00 today. But what might it be worth after 5, 10 or 20 years? Although the exempt amount will increase over time, it is limited only to the rise in the Consumer Price Index. Good investments, small business, or real estate could grow at a higher rate over time. Leaving your spouse to deal with future growth and its tax problems can be a burden. With a bypass trust, you can shift future growth out of your spouse’s estate and still allow him or her to benefit from the assets by leaving some of them to the trust.
- The Grandparent’s Tax. ATRA preserved the Generation-Skipping Transfer Tax (“GSTT”). This tax is imposed whenever a grandparent leaves assets directly to grandchildren skipping a generation. As of 2016, there is a $5.45 million exemption to the GSTT (it adjusts annually for inflation, however, there is no portability to that exemption. If your estate is very large, you might still wanted to consider a bypass trust to preserve the GSTT exemption. Your estate might not be valuable enough for this to be an issue, but for some it is something to consider and discuss with your attorney.
- State Taxes. Many states have a state or inheritance taxes or both. Most of them have exemptions far lower than the federal exemption, and very few have a portability provision. If your state is not one that has abolished death taxes, you might want a bypass trust to reduce state taxes.
- The Remarriage Glitch. When the surviving spouse remarries, the portability of the first spouse’s unused exemption becomes uncertain. When the surviving spouse’s second spouse passes away before the surviving spouse, the surviving spouse has available only the unused exemption of his or her second If it is less than the unused exemption of the first spouse, that is too bad. The first spouse’s unused exemption is lost. But if the first spouse had used a bypass trust, the full exemption would have been used at that time. If the surviving spouse remarried and died before the new spouse, the surviving spouse’s estate can use the full unused exemption of the first spouse.
- Other Portability Limitations. Portability is only available for people who are U.S. citizens or residents at the time of their death. Regulations provide that portability is not available to a surviving non-resident alien (except if the survivor is a resident of a country that has an applicable treaty with the United States). Finally, it is of utmost importance that the portability election be made timely. A timely filed election is defined as a return with the proper election filed on or before the due date of the return (including extensions).
ANALYSIS OF PORTABILITY-TYPE PLANS
What do the numbers show? The numbers demonstrate that for combined estates of less than $10,900,000.00 in 2016, a portability-type plan may be more economically beneficial than a trust if:
- One looks purely from a tax saving perspective;
- Where assets appreciate over time; and
- There are no “non-tax” reasons for a particular plan (as enumerated above).
Under most circumstances portability has income tax advantages. We discussed earlier that the “stepped up” basis means that you do not have to pay capital gains on the sale of the decedent’s capital items, such as stocks, as there is a stepped up basis upon the death of the surviving spouse while the same assets appreciating in a trust would not have a stepped up basis. Thus, with the additional income tax benefit, the portability-type plan may outpace the traditional plan.
Portability should not automatically be used. First of all, the “tax-tail” should not “wag the dog”. Estate planning is not just tax planning–it is much more. Estate planning includes planning for tax and non-tax considerations. Thus, even though a portability-type plan may be the most tax efficient, there may be reasons not to implement this type of plan.
For example, if the husband was on his third marriage he and his new spouse may have a prenuptial agreement with provisions that would be inconsistent with a portability-type plan. Or, it could be that the new wife may not trust the husband to make the post-death actions to effectuate the benefits of a portability-type plan.
Portability is simple and can be used even if there was no estate planning prior to the date of death. Portability works well with certain types of assets such as IRAs and retirement plan assets and the home or principal residence. Moreover, under portability, assets get a second step up in basis (the readjustment of the value of an appreciated asset for tax purposes upon inheritance) at the death of the surviving spouse.
Relying on portability also has disadvantages. There is the expense of filing a timely estate tax return, (though there are some simplified procedures for filing just for portability). Also, the spouse’s unused exclusion amount is fixed at the first death and does not increase with inflation. Finally, it can be disadvantageous if you live in (or have assets in) a state with estate-level tax where portability is not recognized.
Credit shelter trusts also have advantages and disadvantages. A credit shelter trust ensures that appreciation of a trust assets and undistributed income will not be subject to federal or state estate tax on the surviving spouse’s passing. The credit shelter trust also provides for asset and creditor protection of a trust. Moreover, the credit shelter trust has a trustee in place to manage assets and financial matters as the surviving spouse ages. On the other hand, trusts have disadvantages. Undistributed income of a trust can be subject to higher income tax rates than individuals. There are annual expenses of filing a trust tax return, fees for keeping separate trust accounts and extra work in reconciling and maintaining trust accounts. Finally there is no step up in basis on assets at the death of the surviving spouse.
Portability can be a valuable estate planning tool and a post-estate planning benefit. Good planning is required for significant estates.