“Portability” of the Federal Estate Tax ExemptionSubmitted by Guidant Planning on May 5th, 2011
By Allen G. Yee
Back in March I wrote an article about Gift Tax in which I describe an exemption opportunity as “a window” that would possibly close in the next 2 years. This month I would like to discuss another window that can also have significant implications as to how your wealth may be passed on. New legislation has added an element of portability to the estate planning process in which the estate of a deceased spouse can transfer to the surviving spouse any portion of the federal estate tax exemption that he or she does not use. The surviving spouse’s estate can then transfer that amount to the exemption it is entitled to. This act can increase the amount of tax-free dollars that can be passed on to heirs. This new feature makes it easier for married couples to minimize the potential impact of estate taxes.
On its face, exemption portability is a good thing. However, like many “good” things from Congress, this one may not be all that it is cracked up to be. Like any tax situation, careful consideration must be given to each individual’s particular situation before attempting to implement strategies.
What is the federal estate tax exemption?
When you pass on, Uncle Sam taxes the value of your property as it passes to your heirs. Any amount that is passed to a surviving spouse is generally fully deductible. The estate is also allowed to exclude a certain amount that passes on to non-spouse beneficiaries. That amount is called the “basic exclusion amount,” which is $5 million in 2011 and 2012.
Exemption works differently between direct transfer to spouses. Prior to the new tax law, if a spouse died without having planned for his or her exemption, the deceased spouse’s estate would have passed tax free to the surviving spouse under the unlimited marital deduction (assuming all assets passed to the surviving spouse), and the deceased spouse’s exemption was lost or “wasted.” The surviving spouse’s estate could then only transfer an amount equal to his or her own exemption free from federal estate tax. To solve this dilemma, married couples typically set up what is commonly referred to as a credit shelter trust (aka “bypass” or family trust) that sheltered or preserved the exemption of the first spouse to die.
The following examples illustrate how portability can achieve a similar result without the use of a credit shelter trust.
Assume John and Jane are married, have all of their assets jointly titled, and have a net worth of $10 million. John dies first, when the federal estate tax exemption is $5 million and there is no portability. John’s estate passes to Jane free from federal estate tax under the unlimited marital deduction and does not use any of his $5 million exemption. Assume that at the time of Jane’s death, the exemption is still $5 million, the federal estate tax rate is 35%, and Jane’s estate is still worth $10 million. With John’s exemption completely wasted, Jane can pass on only $5 million free from federal estate tax. Assuming no other variables, Jane’s estate will owe about $1,750,000 in federal estate tax: $10 million estate – $5 million exemption = $5 million taxable estate x 35% estate tax rate = $1,750,000.
Assume John and Jane are married, have all of their assets jointly titled, and have a net worth of $10 million. John dies first, when the federal estate tax exemption is $5 million and there is portability. As above, John’s estate passes to Jane free from federal estate tax under the unlimited marital deduction and does not use any of his $5 million exemption. Even though John’s estate owes no tax, John’s executor files a timely return on which he elects to transfer John’s unused exemption to Jane. Assume that at the time of Jane’s subsequent death, the exemption is still $5 million, the federal estate tax rate is 35%, and Jane’s estate is still worth $10 million. Since Jane has “inherited” John’s unused exemption, she can pass on the entire $10 million estate free from federal estate tax. Portability of the estate tax exemption saves John and Jane’s heirs $1,750,000 in estate tax.
Despite the possible advantages portability can have, there are still many factors to contemplate. In the end, using a credit shelter trust may be what best suites your individual situation. One factor to consider is time. Effective for only two years, portability will expire after 2012, unless Congress enacts further legislation. The trust can help protect assets against creditors of the surviving spouse or future beneficiaries (typically children and grandchildren). Another factor is control. The trust allows the first spouse to die to control the ultimate distribution of his or her assets. For example, in a second marriage situation, one spouse may wish to ensure that any assets remaining after his or her spouse’s death pass to his or her children from a previous marriage. Appreciation of assets placed in the trust will escape estate taxation in the survivor’s estate. There are also limitations to the portability option. Portability feature applies only to estate tax; it does not apply to the generation-skipping transfer (GST) tax. Without a trust, any unused GST tax exemption of the first spouse to die is lost.
Information gathered from Forefield, Inc. Copyright 2011 Forefield, Inc