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Planning For Portability

In a world of smartphones and tablets, portability is something we take for granted in our gadgets. But thanks to some recent legislative changes, it is now something that estate planners can take for granted too.

Portability, as it applies to federal estate and gift taxes, is a relatively new concept. It was introduced in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, and became permanent with 2012’s American Taxpayer Relief Act. So what is portability? In a nutshell, portability allows a married couple to treat their two individual estate tax exemptions as if it were one large combined exemption. If one spouse dies and the value of his or her estate does not use up the entire individual exemption, the remainder can be transferred over to the survivor. The surviving spouse can then apply his or her own exemption plus the leftover exemption, without the need for any of the traditional tools of estate planning for couples.

This new option is incredibly useful, though like any other estate planning tool, portability is not a cure-all. For instance, it does not apply to Generation Skipping Transfer Tax (GST) exemption. And while the individual exclusion is adjusted for inflation, once the unused exemption is transferred, it is not adjusted as time passes. Still, portability offers a relatively simple way to capture unused exclusion that, prior to this option, would either require complicated planning solutions or risk going unused.

While portability is available to all U.S. citizens, it isn’t quite automatic. The deceased spouse’s executor must timely file a complete Form 706 to elect portability of the deceased spouse’s unused exclusion amount (DSUE). A timely filed Form 706 with DSUE is, itself, deemed a portability election; there is no box to check to indicate the affirmative choice of making the election, only one to indicate the negative.

If portability is so useful, you may wonder why anyone would want to opt out of receiving their spouse’s unused exclusion. However, every couple’s situation is unique. In truth, both portability and more traditional estate planning methods, such as credit shelter trusts, can offer advantages.

Advantages of Electing Portability

The greatest advantage portability has to offer is its simplicity. For many couples, it may now be practical to leave all property to a surviving spouse, either outright (what estate planners often call a “sweetheart will”) or in trust, and still preserve any unused exclusion amount. Especially for couples whose combined assets fall below the exclusion amount, portability rules can save a lot of inconvenience and expense by eliminating the need to divide ownership of assets in a way that will take maximum advantage of their individual exclusions.

For many couples, a large concern in their estate planning has been a primary residence, which may represent a substantial portion of the couple’s wealth but is generally not an asset that it is practical to use when funding a credit shelter trust. Formerly, a couple might transfer the home fully to one spouse or another, gambling on which spouse would die first; alternately, a spouse might leave his or her stake in the home to a trust, necessitating aggravating and expensive administrative burdens for the survivor in allocating expenses and tracking payments. Portability does away with the need for these awkward arrangements.

Portability allows all assets the benefit of a basis step-up at the death of the second spouse. Assets passing to a trust would not receive this benefit. A basis step-up potentially saves income tax on the increase between the value of the asset at the first spouse’s death and the value of the asset at the death of the surviving spouse. As discussed later, the flip side to this benefit is estate tax, if you are subject to it, which will be assessed on the appreciation.

Advantages of Credit Shelter Trusts

Before portability existed, couples often turned to credit shelter trusts in order to fully use the first spouse’s applicable exclusion amount, leaving the remainder of assets to a marital trust or marital gift. For some couples, this may remain a better option. There are several reasons that this might be the case.

First, as mentioned above, the unused exclusion is not indexed for inflation once it is transferred to the surviving spouse. A credit shelter trust offers the opportunity for assets to appreciate freely outside the estate, without causing the value of the survivor’s estate to balloon while only part of his or her exclusion keeps pace. Especially for a younger couple, where it is reasonable to assume a survivor would live for decades after the first spouse’s death, the tax savings could be significant. And, while the current exclusion is “permanent,” indexed for inflation, it is also important to bear in mind that Congress could always pass legislation to lower that threshold in the future.

Another concern, especially in cases where a survivor has many years of expected life remaining, is the effects of remarriage on portability. The “last deceased spouse” rule means that a survivor is entitled only to the exclusion of his or her last deceased spouse, regardless of the relative amounts involved. For instance, John predeceases his wife Annie, leaving $2 million in unused exclusion, which John’s executor elects to permit Annie to use. Annie subsequently marries George. When George dies, he leaves only $1 million in unused exclusion. Since he is the last deceased spouse, Annie can use his $1 million exclusion, but she can no longer use John’s $2 million. If John and Annie had used a credit shelter trust instead of portability, however, George’s death would not affect the exclusion allocated to the trust from Annie’s first marriage in any way.

In addition, as the name implies, a credit shelter trust provides protections from claims of creditors and provides greater flexibility regarding use of the trust property for descendants, as well as a spouse. Also as mentioned above, portability does not help in situations where GST is a concern. A couple wishing to maximize property that will pass to descendants in a skip generation may find credit shelter planning a much more effective means of pursuing their goal.

Married couples who have children from prior marriages, or other non-standard family situations, should also be wary of relying fully on portability. Portability allows a surviving spouse to use the remaining exclusion personally, with no obligations to regard the needs of the deceased spouse’s beneficiaries. In the past, an individual who has remarried but wishes to provide for children from an earlier marriage would often set up a QTIP trust for the new spouse, with assets eventually passing to the children. Portability, however, can undermine a plan based on a QTIP trust, since the spouse receiving the unused exclusion can apply it in such a way that the QTIP does not receive the benefit. A credit shelter trust plan may often be a more prudent course of action. Alternately, such issues could be addressed in a prenuptial agreement.

The couples who will benefit most from portability are those for whom assets are likely to exceed the individual exclusion amount but are unlikely to exceed twice that much. For couples with much smaller estates, federal estate tax will likely not be a worry in the first place; for couples with much larger estates, traditional credit shelter trust planning will likely make more sense mathematically, since they will likely have to pay at least some estate tax no matter how they plan.

The trick, however, is that it can be difficult to predict whether a couple will occupy the portability sweet spot at the time they sit down to draft their estate plan. When considering how fully to rely on portability, couples and the professionals they employ should consider various factors, including: the spouses’ ages and general state of health; the couple’s current projected estate tax liability and income tax rates; the types of assets involved and those assets’ growth potential; the projected needs of the couple’s children, if any; and whether the couple’s state of residence levies a state-level estate tax. Planners and clients alike should remain cognizant of the fact that “permanent” has different meanings when used in politics and the tax code.

There are ways to create an estate plan that defers the question of the portability election. One example is a disclaimer plan, which leaves the first spouse’s assets directly to the survivor, but allows the survivor to disclaim them. If the assets are disclaimed, they pass to a credit shelter trust, either for the benefit of the surviving spouse or for the benefit of both the spouse and descendants. This preserves flexibility, but relies on the survivor remembering to promptly disclaim assets if they wish to go that route.

As you can see, portability does not eliminate the need for transfer tax planning altogether, but it can streamline the process for many couples. While it is important not to let the pursuit of simplicity drive you to a less beneficial outcome, portability is a powerful estate planning tool that lawmakers have promised will remain for at least the immediate future.

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