“Portability”: What In The World Is That?
“Portability” refers to the provisions of the American Taxpayer Relief Act of 2012 (“ATRA”) which allow a surviving spouse to elect to retain the “deceased spousal unused exclusion” amount (“DSUE”): the amount of unused Federal 1 estate tax/gift tax exclusion attributable to the deceased spouse. (As used in this article, the first spouse to pass away us called the “deceased spouse”, while the other is called the “surviving spouse”.) The adoption of portability has changed the landscape in the world of estate planning.
Every person has a certain amount of exclusion available to them to shield their assets from federal estate tax. This current amount is $5,450,000 (2016). Thus, if the estate does not exceed those limits upon their death, no federal estate tax would be due. Assuming we are dealing with a married couple, each spouse has an exclusion in that amount, so that together they have $10,900,000 at their disposal.
Prior to portability, when the first spouse died, their exclusion had to actually be used when their estate was settled, or it would be lost. A lot of estate planning focused on how to use up the first spouse’s exclusion. As background, it should be understood that there is no estate tax when property is passed to a spouse. However, gifts to children (or others) are subject to the tax. This created a conundrum.
All things being equal, one would want to pass all of the property to the surviving spouse, so that they could use it to support themselves during their lifetime, after which they would pass it onto the descendants. However, if you gave all the assets to the surviving spouse, it would all be in their estate at the time they pass away, but they would have only their own exclusion amount to shield those assets from tax. Again, unless the deceased spouse’s exclusion was used at their death, it was lost. On the other hand, if you gave it to the descendants at the deceased spouse’s death, which would utilize the deceased spouse’s exclusion, then the assets wouldn’t be available for the support of the surviving spouse during his/her lifetime.
The estate planning solution to this problem was to set up several trusts which went into effect when the decedent spouse passed away. One would be earmarked for the descendants, but would remain in trust, to be finally distributed to them only upon the death of the surviving spouse. This trust (called the “bypass trust” or “credit shelter trust”) would contain the optimal amount use as much of the deceased spouse’s exclusion amount as was necessary to eliminate estate tax, leaving all of the rest to go directly to the surviving spouse. Even better, the assets in the bypass trust would be available for use by the spouse, although in a limited fashion (normally, they could obtain the income). These assets would not be considered part of the surviving spouse’s estate when he/she died, so that the exclusion attributable to them would be adequate to protect the amount passed at that time. This was a workable, although cumbersome solution.
However, portability changed all that. By allowing the surviving spouse to use the entire exclusion of both spouses on his/her death – both the exclusion attributable to the surviving spouse, as well as the DSUE (deceased spousal unused exclusion amount) – it seemed to do away with the need for the bypass trust.
Portability Is Not Always the Answer; Bypass (Credit Shelter) Trusts Still Have Their Place
However, the picture is not necessarily so clear. First, in order to have the DSUE available, the surviving spouse must file the election, utilizing IRS form 706, within 9 months of the deceased spouse’s passing. Form 706 is the standard Estate Tax Return, which would not otherwise have usually have to be filed, because no estate tax would be due, particularly in smaller estates. This filing will require help from an accountant, and possible appraisal of some assets. Furthermore, often the surviving spouse will simply neglect to do it, because they don’t appreciate the need to seek advice on the first spouse’s death. And, once the election is made, it is irrevocable, even if it later turns out to have become inconvenient.
Relying on portability –instead of a bypass trust – also means relying upon the surviving spouse to actually carry out the wishes of the deceased spouse, even when they may not want to. Remember that by passing all of the property to the surviving spouse, they obtain full title and control to all of the property, including the right to leave it to someone other than the original beneficiaries. So, if they believe that they are likely to remarry, or the property was intended to be left to the deceased spouse’s children of a prior marriage, the expectations of decedent spouse might not be carried out. In this instance, bypass trusts would prevent the surviving spouse from diverting the trust assets, while still allowing them access to the assets for support, are useful. A marital trust (“QTIP”) could also be used, but would give the surviving spouse greater leeway to use the assets.
Another issue is the effect of remarriage of the surviving spouse on the portability exemption. If the surviving spouse remarries, the portability exemption of the deceased spouse would be lost, since the general rule is the only the most recent spouse’s portability exemption is available to the surviving spouse’s estate. If the surviving spouse remarries someone who has or will use much of their own exclusion, surviving spouse may not have enough available at his/her own death to cover the assets of his/her estate. Use of a bypass trust, instead of relying upon portability, can ensure that the original spouse’s exclusion has been used at the time of their death.
Bypass trusts remove assets from the estate of the surviving spouse. This can have beneficial effects. For one thing, by removing assets from the ownership and control of the surviving spouse, it can remove them from the reach of the surviving spouse’s creditors, protecting the assets from his or her debts and liabilities. Additionally, where there are appreciating assets, which might cause the surviving spouse’s estate to later exceed the limits, placing them in the bypass trust would remove them, and their appreciation, from that estate. The estate tax (and exclusion needed) regarding those assets would be calculated at the death of the first spouse – before the appreciation – and not at the death of the surviving spouse- after the appreciation. The property is considered to have already “passed” to the beneficiaries, so there will be no estate tax on the appreciation.
This also provides another benefit as well; an alternative timing for the step-up in capital gains basis. Under portability, the step-up would occur entirely at the surviving spouse’s death. While in many cases that would be beneficial, there are instances where it would not. For example, where the appreciating asset is likely to be sold before the death of the surviving spouse. In that case, under portability, the surviving spouse would have to pay capital gains tax at sale based upon the original basis, with no step-up at all. With the Bypass trust, a partial step-up occurred at the death of the deceased spouse.
Often times, when the trust is drafted, it is unclear whether portability or a bypass trust will be appropriate at the time that the deceased spouse passes away. Accordingly, many people rely upon a “disclaimer trust” to delay the decision until that death. The “disclaimer trust” gives the surviving spouse the ability to decide – at the time the deceased spouse passes away, and with the advice of attorney and accountant – whether to accept all of the decedent’s property and take the portability election – or to “disclaim” (give up) a portion and put it into a bypass trust. The advantage is that the size and composition of the estate will be much clearer at that time: whether the estate has grown more than anticipated, and whether the income tax capital gains “step up” (or down) is more useful than not. This flexibility also protects against the possibility of interim changes to the estate tax law by Congress. However, this approach does put the power to decide solely in the hands of the survivor spouse; the existence of children of a prior marriage and the likelihood of remarriage should be considered when a disclaimer trust is discussed.
One further point on the limitations of portability is that it does not apply to generation-skipping tax. That tax is levied on assets that “skip” generations: the IRS assumes that when assets are passed directly to grandchildren (or anyone more than 37 years younger than the settler) estate tax would have been levied when the assets were passed to the parents of the beneficiary, so they impose that estate tax because that tax was “skipped”. In essence, you are responsible for double estate tax when giving gifts to grandchildren. Since portability does not apply to generation skipping tax, only one individual’s exclusion amount can be used to protect assets from this tax. Therefore, where an estate leaves substantial assets to grandchildren, whether outright or in trusts, a generation skipping trust should be considered.
In conclusion, portability is a valuable estate planning tool, which will make estate planning easier and less complex, particularly for lower valued estates. However, it is not a panacea, and whether it should be relied upon must be considered in relation to the specifics of each individual case.1This article deals with Federal estate tax planning. Some states collect their own estate tax, which may require estate tax planning specifically aimed at dealing with those taxes. Insofar as my estate planning practice is limited to California, where there is no State estate tax, I do not deal with these issues. Please consult a local attorney if you live elsewhere than California. Also, in general, this article deals with general topics of law, which may or may not be applicable to your situation, and which is not intended to, and is not, legal advice to be relied upon by any reader. You should consult an attorney for any advice, and fully apprise them of your individual situation.