Pasternak & Fidis Reporter

October 1, 2014

Tax Planning, the Federal Estate Tax and Portability

The federal estate tax is a tax imposed on the value of assets includable in a decedent’s estate. However, each person has an exemption amount. The federal estate tax exemption is the total amount a person can transfer to any benefi ciary without paying estate tax. In 2014, the federal estate tax exemption is $5.34 million and is indexed for inflation in future years. The federal lifetime gift tax exemption is unified with the federal estate tax exemption. This means that a person can use some or all of the federal lifetime gift tax exemption during his or her life and that will reduce the amount of federal estate tax exemption available at death. In 2014, each person’s lifetime gift tax exemption is $5.34 million. The federal estate tax rate is 40 percent of the amount over the exemption. In addition, a married person can transfer an unlimited amount to his or her spouse during lifetime through gifts or upon death due to the unlimited marital deduction.

On January 2, 2013, the American Taxpayer Relief Act of 2012 made “portability” (a tax-planning opportunity for married persons) permanent in the tax code. Prior to the advent of portability, every individual was limited to his or her own federal estate tax exemption. If the first spouse in a married couple died without fully using his or her exemption, the remaining exemption was lost.

What Is Portability?

Portability is a tax election that is available only to married couples. The election transfers a deceased spouse’s unused federal estate tax exemption amount (the “DSUE Amount”) to his or her surviving spouse. The surviving spouse may use this “ported” DSUE Amount, in addition to the surviving spouse’s own federal estate and gift tax exemption amount. The DSUE Amount may be used (i) during his or her lifetime to shelter any taxable gifts from federal gift tax, and/or (ii) at his or her later death to shelter assets from federal estate tax. In other words, portability allows a surviving spouse to take his or her predeceased spouse’s unused federal estate tax exemption and add it to his or her own federal exemption. The combination of both amounts is referred to as the surviving spouse’s “Applicable Exclusion.”

An Example

Harry and Wanda are married. Harry dies in 2014 using $3 million of his $5.34 million federal estate tax exemption. The personal representative of Harry’s estate makes the portability election on his federal estate tax return. As a result, Wanda will have (i) her own federal estate and gift tax exemption ($5.34 million in 2014, assuming she has not previously made any taxable gifts), plus (ii) Harry’s DSUE Amount ($2.34 million). The combined $7.68 million is Wanda’s Applicable Exclusion. She can use it (i) to shelter lifetime gifts from the federal gift tax, and/or (ii) to shelter assets from the federal estate tax at her death. IRS Treasury Regulations provide that, if Wanda makes lifetime gifts, she will consume Harry’s DSUE Amount fi rst before she begins to consume her own federal exemption amount.

Estate Planning and Portability

One of the tax policy rationales behind portability was to make estate planning easier for married couples. However, married couples should carefully consider their personal family situation and the use of other estate planning techniques in combination with portability, rather than relying solely on portability.

First, portability is limited. Only the federal estate tax exemption is portable. The Generation Skipping Transfer (“GST”) tax exemption (for transfers to grandchildren and more remote descendants) is not portable. Because portability does not apply to the GST tax exemption, the fi rst deceased spouse’s GST exemption may be wasted if a couple fails to engage in appropriate estate planning.

In addition, portability is currently unavailable for estate tax purposes at the state level in Maryland and the District of Columbia. In 2014, each of these jurisdictions has an estate tax threshold of $1 million. (Virginia does not have a state estate tax.) Legislation enacted in 2014 will increase the Maryland estate tax threshold over the next several years: to $1.5 million in 2015; $2 million in 2016; $3 million in 2017; and $4 million in 2018. In 2019 and later years, the Maryland estate tax threshold will recouple with the federal estate tax exemption (projected to be $5.9 million by 2019 as a result of infl ation), meaning that the Maryland and federal exemption amounts will be the same. In 2019 and later years, portability will apply for Maryland estate tax purposes. Similarly, in 2014 the D.C. City Council voted to raise the D.C. estate tax threshold beginning in 2016, but implementation will depend on future revenues. Estate planning is necessary to ensure that the first spouse to die does not waste available exemptions.

Second, relying solely on portability of the federal estate tax exemption, in lieu of using a trust and other planning techniques, overlooks all of the other benefits of leaving assets in trust, such as creditor protection, control over the ultimate disposition of the trust assets, confidentiality, protection from a future remarriage of the surviving spouse, and asset management for beneficiaries who cannot manage assets for themselves.

Third, the DSUE Amount from the first deceased spouse can be inadvertently forfeited. The DSUE Amount will be forfeited if the surviving spouse remarries and subsequently also survives his or her new spouse. A surviving spouse can avoid forfeiture of the DSUE Amount by using it to make lifetime gifts before his or her new spouse dies. Thus, it is important for surviving spouses to attend to their estate planning to consider whether it is appropriate to use the DSUE Amount for lifetime gifts.

Finally, despite Congress’ objective of simplifying estate planning for married couples, portability can quickly become quite complicated. This is especially true for blended families where the decedent’s children, on the one hand, and the surviving spouse, on the other, may have confl icting interests. For example, the surviving spouse gets the DSUE Amount only if the deceased spouse’s estate fi les a federal estate tax return to make portability election. If the federal estate tax return is not otherwise required, a decedent’s children (who may be inheriting the estate’s assets) may not want to pay to prepare and fi le an estate tax return just to elect portability to benefi t a stepparent. Additionally, a surviving spouse, once he or she has the DSUE Amount, may use it on lifetime gifts to his or her own children to the exclusion of the predeceased spouse’s children. This may be contrary to what the predeceased spouse may have intended in relying on portability of the estate tax exemption. Engaging in estate planning (and carefully crafting provisions in a comprehensive premarital or postmarital agreement to address these concerns) can help to minimize the potential family conflicts that may arise with portability.

Same-Sex Couples and Portability

After the 2013 Supreme Court decision in U.S. v. Windsor, portability applies to same-sex married couples in the same way it applies to heterosexual married couples. Windsor held that the federal government could not deny recognition, at the federal level, to a same-sex couple who validly marry in a state that recognizes same-sex marriage. The IRS has taken the position that it will treat such a couple as married even if they move to a non-recognition state. Thus, they are entitled to use portability, the unlimited marital deduction, and all other estate tax planning techniques available at the federal level. A same-sex couple who lives in a non-recognition state will need to consider their own state’s estate or inheritance tax laws as part of their estate planning.

Conclusion

Portability is only one of many tools in the estate planning toolbox. It should be subject to the same thoughtful analysis as any other technique. Utilizing trusts and other estate planning techniques in conjunction with portability can provide signifi cant fl exibility by allowing complicated taxplanning decisions to be deferred until unknown variables become known. These unknown variables include the date of death, the exemption amounts, asset values and cost bases, and the dynamics of the family relationships at the time of the first spouse’s death. In certain situations, as a result of increased income tax rates, income tax planning for preservation of family wealth may be a key consideration. To learn more about portability and other estate planning opportunities, please contact any attorney in the Estate Planning and Administration Group.