Portability Rules Not a Perfect Solution

Question:  Due to the estate tax portability rules, do I really need to maintain my current estate plan which creates marital and non-marital trusts for the benefit of my spouse upon my death?

 Answer:  Congress instituted estate tax portability into the Federal estate tax scheme several years ago.  The portability rules permit the surviving spouse of a deceased taxpayer to utilize the unused estate tax exemption of the first spouse to die.  With a current Federal estate tax exemption of $5,430,000, the portability rules potentially allow a surviving spouse to transfer $10,860,000 of assets free of Federal estate tax.

Many taxpayers have created estate plans designed to utilize the Federal estate tax exemption of the first spouse to die.  On the first spouse’s death, assets are allocated to one or more trusts for the benefit of the surviving spouse.  The intention is to utilize the Federal estate tax exemption of the first spouse to die while enabling the surviving spouse to utilize his or her Federal estate tax exemption on the survivor’s death, thereby permitting the couple to fully utilize their Federal estate tax exemptions.  The portability rules, however, are not as effective for estate tax purposes for various reasons:

  1.  State Estate Taxes.  The portability rules may not permit the surviving spouse to utilize the unused State estate tax exemption of the first spouse to die. In a State such as Illinois which has a separate estate tax, a meaningful amount of property could be subject to Illinois estate tax if portability is the foundation of estate tax planning.
  2. Asset Appreciation. Where a trust is created on the death of the first spouse to die and will be exempt from estate tax on the second spouse’s death, any appreciation in the value of the trust assets after the death of the first spouse will escape estate tax on the surviving spouse’s death.  Reliance on the portability rules could result in additional estate taxes on the surviving spouse’s death as all appreciation in the value of assets following the first spouse’s death may be subject to tax when the second spouse dies.  It is noteworthy that there could be an income tax savings through the portability rules as an increased basis for income tax purposes in the assets can be realized on the death of the first spouse to die.  However, with Federal estate tax rates generally higher than income tax rates, reliance on the portability rules could be more costly.
  3. Last Spouse Only.  The portability rules only permit a surviving spouse to utilize the unused Federal estate tax exemption of the surviving spouse’s last spouse.  Upon remarriage, the surviving spouse forfeits the unused Federal estate tax exemption of the previous spouse.  The surviving spouse can make lifetime gifts before remarriage to utilize the unused exemption of the first spouse to die but the surviving spouse may not have the resources nor the desire to do so.
  4. GST Exemption.  Transfers to grandchildren and other remote beneficiaries could be subject to an additional tax known as the generation-skipping tax.  Each taxpayer has a generation-skipping transfer (“GST”) tax exemption equal to the amount of the taxpayer’s Federal estate tax exemption.  Unlike the Federal estate tax exemption, the GST exemption is not portable.  A couple planning to make gifts to grandchildren and beneficiaries in generations more remote than their children may forfeit part of their GST exemptions by not engaging in proper planning. 

The portability rules no doubt provide considerable advantages for couples potentially subject to estate taxes.  In most cases, the portability rules are not as effective of a tool in circumventing Federal and State estate taxes as a properly planned estate while both spouses are alive. Blindly relying on the portability rules is clearly not recommended.

 

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want to be answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.