The federal estate tax landscape has changed dramatically in the last several years, since the “sunset” of the Economic Growth and Tax Relief Reconciliation Act of 2001. And yet, it has changed very little. After that law expired, or “sunset,” Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, which allowed a surviving spouse to “port” the decedent’s unused exclusion amount to the surviving spouse’s own transfers during life and at death. And thus, “portability” was born.
Under the 2010 Act, portability was scheduled to expire on January 1, 2013, but the American Taxpayer Relief Act of 2012 (passed in January of 2013) made portability “permanent.”
What is “Portability”?
Under prior law, if a spouse died without having planned for his or her exemption, that exemption was lost. In other words, a married couple was able to transfer a combined $10 million of assets ($5 million each, indexed for inflation; in 2014, the indexed exclusion is $5.34 million) free of federal estate tax, but only if they set up what is commonly referred to as a credit shelter trust (aka “bypass” or family trust) for the $5 million of the first spouse to die. This trust “shelters” or preserves the federal estate tax exemption of that spouse so that it is not lost at death. Without such a trust in place, the first spouse to die wastes his or her exemption and the surviving spouse can only transfer $5 million free from federal estate tax. (Note that the state estate tax exemption may be less than $5 million, as discussed below; in Illinois, the state estate tax threshold is $4 million, for instance).
Under portability, when the first spouse dies, the unused exemption simply transfers to the survivor and is available for use when that spouse dies. In other words, the surviving spouse will have both spouses’ federal exemptions to the extent that the first spouse to die didn’t use the exemption available to him or her. In some respects, such a change simplifies estate planning for surviving spouses by eliminating the need for credit shelter trusts (either in their wills or as part of a revocable living trust) set up solely to save estate taxes. Also, with portability, couples do not need to retitle assets to equalize their respective estates.
Thus, with portability, a married couple can effectively shelter $10 million for federal estate tax purposes. Does this mean that if a married couple has less than $10 million they no longer need to plan or update their existing planning? Absolutely not.
Shortcomings of Exemption Portability
The biggest shortcoming of federal estate tax exemption portability is the loss of asset protection. By not utilizing a credit shelter trust in a revocable living trust or Will, the assets of the predeceased spouse are transferred directly to the surviving spouse and thus become available to creditors and are subject to division in a future divorce. While you may not believe that you are at risk for claims against these assets, consider this: a single car accident can result in a judgment that far exceeds your insurance limits, even where you believe that you are not at fault.
Planning Tip: Through the use of a properly drafted credit shelter trust, the assets in the credit shelter trust will never be subject to creditors of the surviving spouse or future beneficiaries, often children and grandchildren.
Additionally, assets in a credit shelter trust are not subject to federal estate tax no matter how much they grow during the surviving spouse’s lifetime and beyond. Both the growth of the assets and all income that they generate can be sheltered from being taxed in the estate of the surviving spouse. Therefore, these assets can grow well past $5 million and never be subject to federal estate tax. On the other hand, the growth in assets outside a trust, in the hands of the surviving spouse, will not be protected. This inflation protection is not available if credit shelter planning isn’t done before the first spouse dies.
Planning Tip: Your investment advisor can continue to invest these assets and grow them significantly over time without imposition of federal estate tax.
Furthermore, more and more states have state estate tax exemptions that are less than the federal estate tax exemption. Thus, while your surviving spouse might not be subject to federal estate tax upon your passing, your surviving spouse may have to pay significant state estate tax if you rely solely on the federal exemption portability. This is true even if you live in a state that does not currently have a state estate tax as it might institute one, or you might someday move to such a state or own property there.
Last, but not least, there is nothing to prevent Congress from changing the rules in the future. Congress continuously tinkers with the estate tax, and has done so nearly 20 times since 1976. What is to prevent Congress from doing so again, especially if the United States needs to raise revenue? And if one spouse has already died, it will be too late.
Planning Tip: Congress has continuously tinkered with the federal estate exemption amounts and the estate tax rates. There is no reason to believe that Congress will not continue to tinker with these in the future.
Best of Both Worlds
Relying on portability alone is not an effective estate tax planning strategy. But using the flexibility that portability provides, as a part of your overall estate plan, can enhance the opportunities available to you. You are able to take advantage of the asset protection and hedge against inflation provided by by-pass trusts, but yet use portability to reassess your strategy at the death of the first spouse to die.
Planning Tip: Set up your estate plan to protect your surviving spouse’s inheritance from creditors’ claims and limit any estate taxation because of the growth of that inheritance through the use of a by-pass trust. At the same time, give the survivor a “second look” to do some “real time” income and estate tax planning after the death of the first spouse to die. Portability gives you the opportunity to have “the best of both worlds.”
Portability of the federal estate tax is an improvement over the prior law whereby the estate tax exclusion wasn’t transferable to a surviving spouse, but it is not a substitute for proper planning or continuous updating of existing planning. As your planning goals or assets change, so too should your estate planning change. By working together, your planning team can ensure that your estate plan stays current and will accomplish your unique goals and objectives.