When Congress passed the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the 2010 Tax Act) in December 2010, it finally provided some guidance and certainty — albeit for just two years — for the estate tax planning world. Most of the characteristics of the estate tax regime created by the 2010 Tax Act resemble the estate tax planning regime in effect during the past decade – unlimited marital and charitable deductions and limited individual exemptions for estate, gift and generation skipping transfer (GST) taxes. Notably, however, the estate tax, gift tax and GST tax exemptions increased to $5 million from the 2009 levels of $3.5 million, $1 million and $3.5 million respectively. Additionally, the 2010 Tax Act created a new concept that had not been a part of the prior estate tax regime – the concept of “portability.”
In basic terms, portability allows a surviving spouse to use the estate and gift tax exemption that went unused by his or her deceased spouse. Recall that historically the use of one’s estate and gift tax exemption was a “use it or lose it” proposition. If an individual did not use his or her exemption, which was most commonly accomplished through lifetime gifting or the establishment of a credit shelter trust at death, the family had no way of benefitting from any unused exemption.
At first blush, the concept of portability appears to greatly simplify estate tax planning with couples whose combined assets do not exceed their combined exemption amounts, currently $10 million per couple. Even without establishing a credit shelter trust at the first spouse’s death, the surviving spouse can still get the benefit of any unused exemption by simply relying on portability. Before tossing existing estate planning documents into the shredder in favor of estate planning documents that rely on portability, such as “I love you” wills or simple trusts without estate tax planning provisions, however, clients should take notice of the many potential pitfalls surrounding portability:
Only the unused exclusion amount of one’s last deceased spouse can be used. Therefore, if a surviving spouse remarries and his or her new spouse again dies first, the unused exemption from the first deceased spouse is lost. The surviving spouse may, however, utilize the unused exemption of the second spouse to die if the executor of that spouse’s estate makes the portability election. In contrast, if a credit shelter trust is established at the death of the first spouse to die, the exemption of both deceased spouses may be fully utilized.
Threat of Decreased Exemption Amounts
The 2010 Act provides that if the estate tax exemption amount goes down after the death of the first spouse to die, portability is limited to the lower exemption amount. For example, if the first spouse dies with a $5 million unused estate tax exemption, but the estate tax exemption decreases to $3.5 million by the time of the surviving spouse’s death, the amount of exemption that is portable is $3.5 million. This results in a loss of $1.5 million of estate tax exemption compared to a scenario where a $5 million credit shelter trust is set up at the first spouse’s death. Further, the portability amount will not go up if the estate tax exemption amount goes up after the first spouse’s death. Thus if the first spouse dies with a $3.5 million unused estate tax exemption and the estate tax exemption increases to $5 million by the time of the surviving spouse’s death, the amount of exemption that is portable is still the lower amount, $3.5 million. It is also important to note that the appreciation of assets in a credit shelter trust is protected from estate tax, whereas the appreciation of assets for which a portability election is made may be subject to estate tax.
Election Must be Timely Made
To use portability, the executor of the first spouse to die must make an election by timely filing an estate tax return (even if an estate tax return would not otherwise be required because the estate is below the filing threshold). Depending on the assets of the estate of the first spouse to die, this can be a substantial undertaking. Once made, the election is irrevocable. Note that a credit shelter trust can be created by the first to die even if no estate tax return is required because the estate is below the filing threshold.
Loss of Nontax Benefits of a Credit Shelter Trust
While estate tax planning is typically the driving force behind the establishment of a credit shelter trust, there are may other benefits to establishing a credit shelter, such as creditor protection from the claims of the beneficiaries’ creditors and ensuring that assets pass to one’s own children and not to a subsequent spouse and/or his or her children if the surviving spouse remarries. Therefore, for many estate planning clients, establishing a credit shelter trust may be advisable regardless of the ability to rely on portability.
2010 Tax Act Expires in 2013
The 2010 Tax Act is set to expire January 1, 2013. Therefore, unless new legislation is passed that continues to allow for portability, portability could only be used where the first spouse dies after December 31, 2010 and the second spouse dies before January 1, 2013. While most commentators believe any new legislation would continue to allow for portability, there is no guarantee portability will continue.
Portability is certainly a welcomed and important new tool available to estate planners. In particular, it will be invaluable for estates where a decedent’s estate plan contains no estate tax planning. Portability also can be an important component for those with borderline taxable estates, estates where retirement assets pass outside of a credit shelter trust directly to a spouse and estates where there are insufficient assets to fully fund a credit shelter trust for the first spouse to die. Because of the potential benefits and pitfalls discussed above, it would benefit the vast majority of fiduciaries of estates of a first to die spouse to discuss the portability election with his or her tax counsel. –Alexander W. Powell Jr.