Portability (and Why Tax Planning Still Matters)

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRA 2010) introduced portability into the estate tax system.  Portability allows a surviving spouse to use a predeceased spouse’s unused applicable exclusion amount, effectively doubling the amount that a married couple can pass to their beneficiaries free of tax.

The  American Taxpayer Relief Act of 2012 (ATRA) made portability a permanent feature of federal tax law. Any applicable exclusion amount that remains unused at the death of the first spouse to die (called the “deceased spousal unused exclusion amount”) can be used by the surviving spouse in addition to the spouse’s own exemption.  Portability applies only for spouses who die after December 31, 2010 (i.e., there is no portability for decedents who died in 2010).

If the surviving spouse has had more than one predeceased spouse, the amount of unused exclusion is limited to (a) the lesser of $5 million or (b) the unused exclusion of the last predeceased spouse.  These limitations are intended to prevent individuals with more than one predeceased spouse from aggregating more than one spousal exemption to increase the amount that he or she can transfer free of tax.

Portability can only be elected on a timely-filed estate tax return of the predeceased spouse whose exemption is intended to be used, regardless of whether the estate of the predeceased spouse is otherwise required to file a tax return.  In other words, to claim the predeceased spouse’s exclusion amount for the surviving spouse, the executor of the predeceased spouse will need to file an estate tax return even if the predeceased spouse’s estate is not taxable.

Note: Tax preparers and those involved in the administration of estates should consider making the election to preserve flexibility, even if the estate tax return is not otherwise required. For some individuals, the portability election should be referenced in the estate plan.  A provision directing the executor or trustee to elect portability of any unused exemption could be prudent, particularly in a second marriage or other situation where family tension is likely.

Why Estate Tax Planning Still Matters

Married couples have been employing estate planning techniques to achieve portability for years.  But this took special planning.  A married couple’s estate plan would usually include a “credit shelter” disposition of assets that would make full use of the applicable exclusion amount of the first spouse to die.   Credit shelter trusts were often used to support the surviving spouse while sheltering the assets from inclusion in his or her estate.

The introduction of portability has some wondering whether traditional estate tax planning is dead.  Is there a need for credit shelter or disclaimer trusts now that a spouse’s unused exemption can be transferred to the surviving spouse by making an election on the predeceased spouse’s estate tax return?

The waters have been further muddied by mixed motives on the part of the estate planning community.  Many who make their living by selling estate plans that incorporate credit shelter planning fear that the new law will make these plans superfluous. Self-interest aside, there really are some compelling reasons to continue to incorporate credit shelter planning (though perhaps in an unintrusive way, such as a disclaimer trust).  Here are a few of those reasons:

  1. No Inflation Adjustment for the Deceased Spouse’s Unused Exclusion– The deceased spouse’s unused applicable exclusion amount is not adjusted for inflation.  While the surviving spouse’s unused applicable exclusion amount will continue to increase in $10,000 increments over time, the predeceased spouse’s exclusion amount is fixed at death.  Consider: Over a 15 year term, a $5 million bequest to a credit shelter trust will be worth around $7.5 million if the CPI rises at its historical rate of 2.56 percent.  In contrast, a surviving spouse’s exclusion amount will be worth only $5 million in 15 years.
  2. Possibility of Spouse’s Remarriage - The predeceased spousal exclusion can only be claimed for the most recently-deceased spouse.  In other words, if the spouse remarries, she can only use the exemption amount of the new spouse.  The exemption amount of the first predeceased spouse will be lost.  This can be avoided with credit shelter planning.
  3. GST Exemption – Only the estate (and possible the gift) tax exemptions are portable.  The GST tax exemption is not.  Use of a credit shelter bequest will provide a convenient way to allocate the predeceased spouse’s GST exemption, ensuring that it is used.
  4. Risk of Failure to Elect Portability - Since portability can only be elected on a timely-filed estate tax return of the predeceased spouse, a failure to file the return could result in loss of the opportunity.  If the estate is not a taxable estate, there’s a good chance that no one will think of filing an estate tax return just to elect portability. This could be disastrous if the applicable exclusion returns to a lower amount in the future.
  5. The Temporary Nature of Federal Tax Law – I’m not a proponent of fear-based planning. But the fact remains that we don’t know what the future holds.  If portability is eventually repealed or modified, those who rely on it as an estate planning device could pay millions in unnecessary taxes.

And those are just the economic/tax reasons.  Sometimes those of us who are involved in sophisticated tax planning forget that a majority of trust planning is not tax driven.  There will still be continued need for trusts to provide asset protection, control the timing and manner of asset distributions, and other non-tax benefits.  If anything, the new law will simply add additional tools to help us reach our clients non-tax goals in a tax-efficient manner.

The introduction of portability into the transfer tax system is a welcome development, but not a cure-all.  There are still reasons to incorporate tax planning into the estate plan.