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Home / Expert Opinion / Estate Planning: The viability of portability after changes to the federal estate tax

Estate Planning: The viability of portability after changes to the federal estate tax

David C. Pettig

The 2010 tax act, affectionately known as the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010,” made significant changes to the federal estate tax, including the increase of the estate tax exemption to $5 million per person, the lowering of the tax rate to 35 percent and the introduction of what is now referred to as “portability.”

Traditional estate planning required that assets equal to or greater in value than the estate tax exemption be owned by each spouse in order to minimize estate taxes and maximize the use of each individual’s exemption. For example, assume: the federal estate tax exemption is $1 million per person; the estate tax rate is 50 percent; the value of W’s assets is $1.6 million and the value of H’s assets is $400,000. If H dies first and leaves his assets to a trust for W, his estate will use only $400,000 of his $1 million exemption. When W subsequently dies, her $1.6 million estate has only a $1 million exemption. An estate tax of $300,000 must be paid on the $600,000 excess. On the other hand, if W & H each owned $1 million of assets, neither estate would have to pay any federal estate tax.

Portability directly confronts this dilemma. Internal Revenue Code section 2010(c) allows W to use H’s unused exemption. In the above example, H’s estate would claim a $400,000 exemption to ensure that his assets will not be taxed. H’s unused exemption ($600,000) can be added to W’s $1million exemption and, together, eliminate the federal estate tax on her $1.6 million of assets.

Although the 2010 tax act is scheduled to “sunset” at the end of this year, there is a strong possibility that the portability provision will continue even if the estate tax exemption and/or the estate tax rates change. The president’s budget proposals for the 2012-2013 fiscal year provide for the reduction of the estate tax exemption to $3.5 million per person and a 45 percent tax rate. They also provide for the continuance of portability.

Of course, nothing in the tax code is as ever as simple as it seems on the surface. There are a number of concerns about the efficacy of the portability provisions. The balance of this article addresses some of those concerns.

Filing requirement

The unused exemption of the deceased spouse can be used by the surviving spouse only if the exemption is claimed on a timely filed federal estate tax return for the first spouse to die. A return must be filed even if it is otherwise unnecessary. For example: H dies in 2012 with assets worth $2 million. His estate is not required to file a federal estate tax return because the value of his estate is less than the $5 million exemption. However, H’s estate must file a federal estate tax return to preserve his unused $3 million of exemption so that it can be preserved for W’s estate. A timely filed return is one that is filed within nine months of the date of death or 15 months if the estate has filed an election to extend the filing deadline.

Who must file?

The statute requires that the executor of the first decedent’s estate must file “a complete” estate tax return. The filing of the return is deemed to be an election to claim portability. The statute and IRS Notice 2011-82 do not address the possibility that the decedent may have all his assets in a revocable trust and not have a probate estate. Additional guidance will be needed and is expected.

What if the executor does not file a return? Without filing a return for the estate of the first spouse to die, portability will not be available for the estate of the surviving spouse. A permutation: H’s estate is worth $500,000. W’s estate is worth $3 million at H’s death. Subsequently, her estate grows in value to equal the then estate tax exemption. No estate tax return was filed for H’s estate. Consequently, an estate tax of $250,000 will have to be paid by W’s estate (assuming a 50 percent estate tax rate).

Can W’s executor sue H’s executor for failure to file an estate tax return, thereby causing an estate tax to be paid? Does H’s executor have a cause of action against the attorney who represented him in the administration of H’s estate?

What if the executor refuses to file? Assume the value of H’s estate is $4 million and W’s estate is $5 million. Also assume that H’s son is the executor of H’s estate, dislikes his step-mother and intentionally refuses to file the election. Does W or her estate have a cause of action against the executor? Similarly, if there is such an estrangement, can the surviving spouse proactively bring a proceeding to require the executor to timely file an estate tax return?

Is there any way to require the executor to file? Very significant tax savings can be achieved by making the portability election. As a result, it seems wise for pre-marital agreements to address the issue of portability, including whether the executor of the estate of the first to die will be required to file a federal estate tax return, even if the estate assets are valued at less than the estate tax exemption. For couples who are already married, a post-nuptial agreement should be considered.

What if the surviving spouse remarries? If W remarries and dies before her new husband, the portability election made in her deceased husband’s estate is available to her estate. However, if new husband dies before W, then only the new husband’s unused exemption can be used in W’s estate. Portability only applies to the most recently deceased spouse.

Can the surviving spouse apply the deceased spouse’s unused exemption to lifetime gifts? Yes.

What happens if the estate tax exemption decreases? Assume H dies when the estate tax exemption is $5 million. H leaves all of his assets to W who already has assets worth $3 million. H’s transfer of assets to W qualifies for the marital deduction and does not use any of H’s estate tax exemption. At that point, W’s total exemption due to portability is $8 million (her $3 million and H’s $5 million. However, if the estate tax exemption is lowered to $3.5 million by the time of W’s death, then her executor can only use $4 million0 of H’s exemption because the maximum portability amount available at that time is $7 million, or $3.5 million from each spouse. Consequently an estate tax will have to be paid.

Portability has the advantage of avoiding the complications and potential pitfalls of equalizing the value of assets owned by spouses. However, it creates its own potential pitfalls and is not a panacea. But, it should be considered as another tool in the estate planner’s tool box.

David C. Pettig, principal with Pettig Torres PC, has been practicing trust and estate law for more than 30 years. He can be contacted at dcpettig@pettig.com or (585) 586-1430.