Portability and the estate tax: Why portability should not replace lifetime transfer tax planning

Issue April 2011 April 2011 By Brian T. Liberis

On Dec. 17, 2010, the Tax Relief, Unemployment Reauthorization and Job Creation Act of 2010 (TRA) was enacted into law.1 The TRA includes a number of provisions that will have a significant impact on estate tax planning, including an increase of the estate tax exclusion amount to $5 million and a decrease of the maximum tax rate to 35 percent.2 One of the more surprising aspects of the TRA, however, was the inclusion of a provision allowing "portability" of a deceased spouse's unused exclusion amount.

The portability provision provides that if a decedent's estate is less than his or her remaining estate tax exclusion, any unused exclusion amount can be allocated to the decedent's surviving spouse.3 The surviving spouse can then apply this exemption to his or her own estate and lifetime gifts, in addition to his or her own estate and gift tax exemption.4

For example, if a husband dies with an adjusted taxable estate of $5 million and leaves all his assets to wife, those assets qualify for the marital deduction. The decedent's $5 million exemption (which went unused because his entire estate qualified for the marital deduction) can then be allocated to the surviving spouse, who could die with a $10 million estate without being subject to the estate tax.

In order for the deceased spouse's unused exclusion amount to be effectively applied to the surviving spouse, the decedent's executor must affirmatively make an election on a timely filed estate tax return.5 Note, however, that unlike the surviving spouse's own $5 million exclusion, the deceased spouse's unused exclusion amount is not indexed for inflation.6

Traditionally, married taxpayers had to plan in order to ensure that each spouse's exclusion amount would not be "wasted" upon the death of the first spouse to die. As noted in the above example, a bequest of all assets to a surviving spouse would qualify for the marital deduction (and would thus result in no tax upon the death of the first spouse to die), but the deceased taxpayer's exclusion amount would go unused, and that unused amount could not be applied to the surviving spouse's estate.7

Upon the death of the survivor, only his or her individual exclusion amount could be applied against the adjusted gross estate. Accordingly, taxpayers have relied on revocable trusts that, upon death, divide their estates into two shares: one share that is funded with assets equal to the applicable exclusion amount (which could be held for anyone, including the spouse) and one share that is funded with the balance, to be held solely for the surviving spouse.

This arrangement (which is often called an A/B trust plan, or credit shelter trust plan), in conjunction with equalizing the value of each spouse's estate during life, allowed each spouse to fully utilize his or her exclusion amount, thereby eliminating estate taxes in the estate of the first spouse to die and eliminating or minimizing taxes in the estate of
the second.

At first blush, it may appear that the enactment of the portability provision in the TRA would eliminate the need for A/B planning. After all, if the applicable exclusion were to go unused in the estate of the first spouse to die, it could merely be transferred to the surviving spouse to be used against his or her own estate. Portability essentially prevents the exclusion from being "wasted" in the estate of the first spouse to die, which would reduce the need for allocation of assets between separate trust funds in order to preserve the exemption.

While portability undoubtedly provides an excellent "fall back" option for married taxpayers who fail to plan their estates, it should not take the place of proper estate planning and should not replace the A/B trust arrangement that has been relied on for years prior to the enactment of TRA. In addition to the myriad of non-tax reasons (probate avoidance, beneficiary creditor protection), there are several purely tax reasons for an individual to continue to implement a credit-shelter trust arrangement rather the relying on portability.

The most obvious reason for continued use of the A/B trust arrangement is that the new TRA portability provision only applies to federal estate taxes and not state estate taxes.8 Absent proper planning, any exemption afforded to a decedent by an individual state can still be wasted, thereby increasing the likelihood for taxation in the estate of the second spouse to die.

For example, Massachusetts allows the equivalent of a $1 million estate tax exemption, with no portability.9 A married couple with an estate of $2 million that plans properly and implements an A/B trust arrangement can avoid estate taxes completely upon the deaths of both spouses. If, in the alternative, upon the death of the first spouse, he or she leaves everything to the surviving spouse, the $2 million would generate a Massachusetts estate tax of $99,600 upon the death of the second spouse.

Furthermore, portability only applies to the unified estate and gift tax exemption and does not apply to the generation skipping transfer (GST) tax exemption.10 Thus, while portability could prevent a decedent's estate tax exemption from being wasted, failure to create an estate plan that allows for allocation of the GST exemption will result in a tax-
inefficient estate.

If a married couple desires to have their assets held for grandchildren and more remote issue, the only way to maximize their GST exemptions would be for each spouse to implement an A/B trust (or other, more sophisticated, trust arrangement) to which each spouse could allocate his or her full GST exemption amount.

In addition, relying solely on portability ignores the potential for appreciation of estate assets occurring between the deaths of the first and second spouse. Assets allocated to a credit shelter trust will be exempt from the estate tax in both estates, even if the assets in such trust increase exponentially.

If, however, all assets pass to the surviving spouse, subsequent appreciation of those assets will be included in the surviving spouse's estate, and that appreciation could increase the surviving spouse's estate to a level that would subject it to the estate tax. This problem is compounded by the fact that, unlike the surviving spouse's exemption, the first spouse's unused exemption amount is not indexed for inflation.

Take the example of a married couple with a combined $10 million estate ($5 million per spouse). Absent adequate estate planning, upon the death of the first spouse, his or her entire estate will pass to the survivor. Assuming no appreciation in the assets, there will be no estate taxes on the death of either spouse.

Suppose, however, that the first spouse's estate consisted entirely of marketable securities that appreciate by 20 percent, or $1 million, before the death of the second spouse. The second spouse's estate would then be valued at $11 million, which would result in a tax of $350,000, even with portability.

If the first spouse had instead allocated assets equal to his or her remaining exclusion amount to a credit shelter trust, the appreciation would not be included in the second spouse's estate, and the entire estate tax could have been avoided. The potential for tax savings is somewhat diluted by virtue of the fact that the assets in the credit shelter trust do not receive the step-up in basis that they would have otherwise received in the estate of the second spouse to die.

Nevertheless, those assets, upon sale, would generate a federal tax of 15 percent on any appreciation after the death of the first spouse, whereas inclusion in the surviving spouse's estate would generate a tax at a rate of 35 percent.11

In addition to the fact that an estate will be tax-inefficient if the decedent relies solely on portability for tax planning purposes, the new law imposes undesirable procedural requirements. In order for the unused exclusion amount to pass to the surviving spouse, the executor of the estate of the first spouse to die will be required to elect this treatment on an estate tax return.

This could result in the decedent's estate filing an estate tax return in a situation where one would not otherwise be required, solely to preserve the portability exemption.

For example, if a decedent died with an estate of $4 million, then technically, an estate tax return would not be required. If, however, the executor wishes to preserve the $1 million of unused exclusion amount, the estate would have to file a return.

Filing an estate tax return that is not required will result in additional costs to the estate, although such costs would likely not be significant for Massachusetts decedents, as a state return would be required in any event for estates greater than $1 million.

Furthermore, it is likely, in an abundance of caution, that a return would be filed in order to make an election even in estates of decedents who properly implemented an A/B plan during their lifetimes. What is really troubling, however, is having to rely on post-mortem action to pass on the remaining exclusion amount to the surviving spouse rather than planning during life to ensure that both exemptions are maximized.

If, for whatever reason, a timely estate tax return is not filed, or if the executor mistakenly fails to make the election to allow the unused exclusion amount to pass to the surviving spouse, such exclusion would be wasted. This problem would be avoided with proper lifetime planning, rather than a reliance on the portability provisions of the TRA.

And finally, implementing a lifetime estate plan rather than relying on portability provides certainty in an area that has been, and likely will remain, unpredictable and in flux. For the time being, the estate tax provisions, including portability, included in the TRA are effective only for the years 2011 and 2012, and they are scheduled to "sunset" thereafter.12

It is not clear whether portability will be extended beyond 2012, nor is it clear how unused exemption will be treated for a decedent who dies between now and the sunset but whose spouse dies after the sunset. It would be unfair for Congress to make ineffective such a provision, but depending on the U.S. Congressional election cycle and future budgetary concerns, it is possible that portability might not be available in the future.

Thus, it makes the most sense to plan accordingly with a well-drafted estate plan rather than relying on portability in an effort to reduce federal estate taxes.

1See Tax Relief, Unemployment Insurance Reauthorization and Jobs Creation Act of 2010, H.R. 4853, 111th (2010).

2Id., § 302 (modifying I.R.C. Sec. 2010(c)); § 302 (modifying I.R.C. Sec. 2001(c)).

3Id., § 303.


5Id., § 303(a)(5).

6Id., § 303(a)(3).

7See I.R.C. §§ 2056(a), 2010(c).

See H.R. 4853, § 101.

9See Mass. Gen. Laws. ch. 65C (West 2011).

10See H.R. 4853, § 102, 303.

11Id., § 101.