Estate Analyst: The Perils of Portability
The Perils of Portability
I don't keep much stuff around
I value my portability
but I will say that I have saved
every letter you ever wrote to me
--"Soft Shoulder" by Ani DiFranco
Portability of a decedent's estate tax exclusion amount to a surviving spouse arrived along with the reinstatement of the Federal estate tax. The provision allows married couples to transfer a collective $10 million estate with more flexibility as to timing.
But there has to be a catch. In fact, there are several. Portability may encourage procrastination rather than planning. There are transfer taxes at the state level to consider, as well as Medicaid. And Congress is always a wild card.
A Surprising Twist
Close observers of the process of restoring the Federal estate tax provided little or no warning that Congress was even considering a portability clause in the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010 (P.L. 111-312). The act was passed by Congress on December 16, 2010, and signed by President Obama on the following day.
Congress had years to either make the repeal of the estate tax permanent (at least on paper) or restore the estate tax in a long-term manner. It could have adopted the consensus view that had bipartisan support and continued with the rates and exclusions that applied in 2009 instead of allowing the full repeal to take effect in 2010. It could have made up for the failure to act in time by enacting reasonable long-term measures that allow and encourage good financial planning.
We now know that Congress took neither approach and provided another stopgap solution that sustains the same uncertainties about the future of applicable transfer taxation rules.
In this context of last-minute tax reforms and stopgap measures, it is somewhat surprising to find a thoughtful innovation such as the portability of unused spousal exclusions for estate tax. But there are several pitfalls and problems that apply. Couples with estates exceeding $5 million should not defer all distributions at the death of the first spouse on the assumption that the surviving spouse will have an exclusion of $10 million, nor should they believe portability will serve as a substitute for good long-term estate planning.
Before vs. After
Travis died in 2006 when there was a $2 million Federal estate tax exclusion amount, but he left his entire $5 million estate to his wife, Trixie. Trixie died in 2009 with an estate of $5 million. She was able to use her own $2 million estate tax exclusion, but $3 million of her estate was exposed to estate tax. Travis's $2 million exclusion was wasted.
In recent years, several basic approaches have been employed to avoid this scenario. Travis could have a) transferred assets directly to beneficiaries other than Trixie to utilize his exclusion; b) transferred assets to a bypass or credit shelter trust that utilized the full extent of his estate tax exclusion, while still keeping the assets from being exhausted by direct transfers to youthful beneficiaries; or c) transferred to a QTIP trust that qualified for the unlimited marital deduction in his estate.
If there had been portability elections in 2006, Travis's estate would have been able to transfer the unused exclusion to Trixie without having to grapple with the intricacies of trusts; he would have simply used an "I love you" will that left everything he had to his surviving spouse.
Now we flash forward to 2011, but the advent of the portability election may not warrant embracing "I love you" wills without some careful scrutiny.
The Marital Lateral
The mechanics of the new portability rule arise in the new subsection 2010(c)(4) of the Internal Revenue Code. A surviving spouse does not automatically have a $10 million exclusion to work with. To qualify to utilize any portion of a predeceased spouse's exclusion there are several preconditions that must be met.
1) The predeceased spouse must have died after 2010.
2) An estate tax return must be filed for the predeceased spouse. This applies even if there is no tax liability.
3) The estate tax return must be filed on time.
4) The estate tax return of the predeceased spouse must elect to transfer the unused portion of the deceased spouse's unused exclusion.
5) The Secretary of the Treasury may examine the estate tax return of the predeceased spouse to verify the availability of the unused exclusion, and this examination is not subject to the statute of limitations applicable to the predeceased spouse.
6) The predeceased spouse's unused exclusion must be calculated by the available exclusion, as adjusted for cost of living, with reduction for any portions of the exclusion allocated to lifetime gifts or transfers at death.
The actual text of the portability provision is added to IRC Section 2010(c) as new subsection (4) and appears within section 303 of the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010. It focuses on the definition of "deceased spousal unused exclusion amount," which has started appearing as the abbreviation DSUEA in professional journals. Here is the pertinent text.
"(4) DECEASED SPOUSAL UNUSED EXCLUSION AMOUNT- For purposes of this subsection, with respect to a surviving spouse of a deceased spouse dying after December 31, 2010, the term 'deceased spousal unused exclusion amount' means the lesser of--
(A) the basic exclusion amount, or
(B) the excess of--
(i) the basic exclusion amount of the last such deceased spouse of such surviving spouse, over
(ii) the amount with respect to which the tentative tax is determined under section 2001(b)(1) on the estate of such deceased spouse."
Those tempted by the easy deferral of all tax planning to the estate of the surviving spouse might be wise to note the adage from Thomas Jefferson, "Never put off till tomorrow what you can do today."
"Never put off
what you can do
This advice is applicable in the exclusion portability context for several reasons.
• Time Limit: Portability will expire in two years. Portability is part of a transfer tax stopgap measure that may be abandoned or modified significantly. The current estate tax was set up to cover 2011 and 2012 but will automatically revert back to 2001 tax rules unless Congress takes action.
It would seem to be a "no-brainer" that Congress would not allow such a thing to take place because there is broad consensus to have much higher estate tax exclusion levels than the $1 million exclusion from 2001. Yet it was also an obvious no-brainer for Congress to act before the full estate tax repeal took effect in 2010, and look what happened. Note: It may take at least one brain cell to implement a no-brainer.
• Inflation: The new $5 million exclusion will be adjusted for inflation starting in 2012. However, no such adjustment will be made for the exclusion that is transferred to a surviving spouse.
Meanwhile, the assets that are transferred to a surviving spouse may appreciate in value. In fact, assets transferred in the current time frame may experience extraordinary levels of growth for two key reasons.
First, assets transferred now or in the near future may still be trading at values that are depressed from their previous highs in 2007.
Second, a significant wave of inflation may result from a variety of factors that include economic growth, rising oil prices, and high debt levels.
With the two-year time limit and inflation in mind, some estates may consider taking advantage of a decedent's exclusion currently, without risking expiration of the transferred exclusion or future inflation of assets that could be transferred sooner.
On the other hand, those who take full advantage of the $5 million unified exclusion by making lifetime gifts during 2011 and 2012 could end up owing taxes if the exclusion is reduced for 2013 after it sunsets.
The portability approach is simple and tempting but has the potential to fail in additional circumstances.
• No GST Portability: Rocky leaves his $10 million estate to his wife, Ramona, and Rocky's timely estate tax return elects to transfer his unused estate tax exclusion to Ramona. At Ramona's death, she has her full $5 million exclusion available, as well as the $5 million from Rocky. Ramona leaves $10 million to her grandson. Her $10 million of exclusion shields her estate from estate tax on that transfer, but only $5 million of the transfer is exempt for generation-skipping transfer tax purposes.
• Remarriages: The surviving spouse will have his or her own exclusion, plus the exclusion of the most recently predeceased spouse. Thus, Ramona may have a total of $10 million of exclusion based on her own exclusion and the exclusion that was carried over from Rocky. This would continue to apply even if Ramona was remarried to Rafael. But if Rafael then died and had already used up $4 million of his own exclusions on lifetime gifts, Ramona would be limited to $6 million of total exclusions--the $5 million of her own exclusion, plus the $1 million that was carried over from Rafael, the most recently predeceased spouse. However, if Rafael's estate made no election to transfer the unused exclusion to Ramona, then it appears that she would be left with just her own exclusion and would not get to use the exclusions of Rocky or Rafael.
• Limited State Exclusion: Rocky and Ramona live in a state with its own estate tax and a $1.5 million exclusion. The state estate tax exclusion is not portable. By relying entirely on the Federal portability provision, Rocky's $1.5 million state estate tax exclusion is wasted.
• Sunset: Even if portability remains in the tax code, the amount of the estate tax exclusion or unified credit may be reduced in 2013 or some subsequent year. The DSUEA is defined in terms of the basic exclusion, which may be a moving target in the future. It is not defined as the basic exclusion on date of death. So the available DSUEA could be reduced if the basic exclusion is reduced in the future.
Prior Taxable Gifts
Now that the estate and gift tax system has been reunified, the way in which estate taxes are calculated has also reverted, and this may have an impact on the use of the DSUEA in certain estates.
As estate planners may recall from pre-EGTRRA days, taxable lifetime gifts made after 1976 end up being included in the taxable estate, and the gift tax paid on the prior lifetime gifts is then credited against the estate tax that is due. Then the available estate tax exclusion is applied.
In the context of the DSUEA, estates that involve taxable gifts made prior to 2011 need to check their math and apply the unified credit approach to calculating estate tax. There are a number of calculation scenarios that are ambiguous and bear close scrutiny in those estates where significant gifts and assets are involved.
A Cloudy Future
Aside from the fact that Congress is unpredictable, there are some portability questions and situations for which rules will be needed. But guidance may lag behind the actual sunset of the law, leaving some questions unanswered.
Example #1: Peter dies, and his estate elects to leave his unused exclusion of $2 million to his wife, Peggy. Peggy gets married again to Paul. Then Peggy dies. Can Peggy's estate borrow from Peter to pay Paul, i.e., transfer Peter's unused exclusion to Paul?
Answer: No. The wording of the new subsection to the code defines the deceased spousal unused exclusion amount (DSUEA) in 2010(c )(4)(B)(i) as "the basic exclusion amount of the last such deceased spouse of such surviving spouse." In this example, the last such deceased spouse is Peggy, so that would mean Paul could make use of Peggy's unused exclusion but not the unused exclusion from Peter.
[Note: Dan Evans, writing in Steven Leimberg's newsletter #1777 points out that example (3) on page 53 of the Technical Explanation by the Joint Committee on Taxation, No. JCX-55-10, has a conflicting result.]
Example #2: After Paul's death, Peggy makes significant lifetime gifts and marries Peter. Do Peggy's gifts use up Paul's unused exclusion first, or are her own $5 million of exclusions used for purposes of calculating what can be transferred to Peter?
Answer: It appears that Peggy must use up her own exclusions first.
Example #3: Same facts, but what if Peter also predeceases Peggy? Does Peggy's estate get to accumulate unused exclusions from multiple successive spouses, i.e., both Peter and Paul?
Answer: Peggy does not get to accumulate unused exclusions from multiple spouses; she is limited to the DSUEA of Peter. But if the DSUEA from Peter is smaller than that of the DSUEA from Paul, then there is a possibility that Peggy's lifetime gifts could have used up more DSUEA from Paul than ultimately was available. It is unclear how that circumstance would be addressed. Would there be a retroactive tax for use of a DSUEA that was later determined not to be available?
Granted, there are more sensible and effective planning techniques available to try to maximize the new portability rule, but life never fails to result in unexpected circumstances that will challenge the parameters anticipated for this rule.
The new law that restored the Federal estate tax provided one of the most unpronounceable tax acronyms of all time (TRUIRJCA) and some rather challenging technical issues.
For the modest marital estate, portability of the applicable exclusion amount of the first spouse to die may not be recognized as a significant event because the second spouse will also have an apparently nontaxable estate. Yet where the surviving spouse may also inherit significant funds, the exemption of an additional $5 million would be worth $1.75 million at a 35% estate tax rate. So filing an estate tax return and making the election for the first spouse may have some relevance after all.
For the larger estate, deferring all assets and exemptions is not a substitute for good planning.
A QTIP trust is a better choice when there are children from a previous marriage. Trust arrangements can better protect business assets from creditors, prepare family members for Medicaid qualification, and provide a structured arrangement for the multigenerational growth of assets.
Still, the availability of the portability election is a useful and interesting new tool for certain estates and is a welcome sign of consideration and creativity from Congressional tax writers.
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