Why the Value of Exemption Portability is Limited

One notable change to estate tax law from last year’s Tax Relief act is the “portability” of gift and estate tax exemptions. For the first time, when one spouse dies, the surviving spouse can take advantage of the deceased spouse’s unused exemption.

The objective of portability is laudable — namely, to allow married couples to take advantage of their combined exemptions without the need for complex estate planning strategies. But on closer inspection, its value is limited.

Use it or lose it

Before portability, married couples who wished to take full advantage of both spouses’ exemptions had to “use it or lose it.” Each spouse had to have enough assets in his or her name to make use of the exemption. If one spouse owned most or all of the couple’s wealth and the “nonowner” spouse died first, the latter’s exemption amount would be wasted.

Also, each spouse’s estate plan had to be designed to avoid taxation of otherwise exempt amounts in the surviving spouse’s estate. Suppose, for example, that each spouse owned $5 million in assets and their wills provided for those assets to pass to the survivor.

The transfer would be tax exempt under the unlimited marital deduction (provided each spouse was a U.S. citizen), but the assets eventually would be taxed in the survivor’s estate. Assuming the survivor had $10 million in assets at death and the exemption hadn’t changed, $5 million would be subject to estate tax. Again, the first spouse’s exemption would be wasted.

Traditionally, the solution to the first problem has been to equalize the spouses’ estates by transferring assets from owner to nonowner. And the most common solution to the second problem has been for each spouse to establish a credit shelter (or bypass) trust.

Generally, credit shelter trusts are funded with the maximum amount that can be sheltered from tax by the deceased spouse’s exemption. The trust pays income to the surviving spouse for his or her life and subsequently distributes the remaining assets to the couple’s children or other beneficiaries.

Because the surviving spouse never gains control, the trust assets bypass his or her estate. In the previous example, the use of a credit shelter trust would have avoided estate taxes altogether. The first spouse’s $5 million exemption amount would pass into the trust. Then, when the surviving spouse dies, his or her exemption would cover the remaining $5 million. In such a case, neither spouse’s exemption would be wasted.

A limited solution

Portability seems to offer a simple solution, allowing couples to make the most of their exemptions without transferring assets or establishing complicated trusts. In most cases, however, it’s no substitute for traditional estate planning. Here’s why:

It’s temporary. Relying on portability is risky because, unless Congress intervenes, it won’t be available after 2012. Even if one spouse dies before portability’s expiration, the surviving spouse must die or use up the deceased spouse’s exemption via lifetime gifts before portability expires, or the exemption will be lost.

It doesn’t protect your assets. Even if Congress extends portability, it won’t protect your assets from your spouse’s creditors, nor will it guarantee that he or she will manage the funds wisely or ultimately pass them on to your children. A credit shelter trust offers creditor protection, management oversight by a trustee you select and assurances that your wealth will ultimately benefit your children.

It doesn’t avoid taxes on appreciation. Unlike a credit shelter trust, portability doesn’t lock in asset values for gift and estate tax purposes on your death, so appreciation can trigger unnecessary tax liability.

Suppose that you and your spouse each own $5 million in assets and that you leave your entire estate to your spouse. If you die in 2012 without having made any taxable gifts, portability allows your spouse to use your entire $5 million exemption. Let’s say portability and the $5 million exemption are made permanent. If, when your spouse dies, the value of your assets has grown to $8 million, the $3 million of appreciation will generate $1.05 million in estate taxes (assuming a 35% rate and that your spouse’s own $5 million exemption is being used to protect his or her original $5 million).

A credit shelter trust would have avoided estate taxes — in both your estate and your spouse’s estate — on the entire $8 million. This is true regardless of whether portability is extended and even if the estate tax exemption has been reduced at the time of your spouse’s death. (Note that assets in your spouse’s name that are in excess of his or her own available exemption at death would still be subject to tax.)

That being said, portability does have one appreciation-related advantage: Unlike assets in a credit shelter trust, assets you’ve transferred to your spouse are entitled to a stepped-up basis when your spouse dies, reducing or eliminating capital gains taxes should your beneficiaries sell the assets. In most cases, however, the immediate estate tax savings produced by a credit shelter trust will outweigh the future additional income tax cost related to having a lower basis.

It doesn’t apply to generation-skipping transfer (GST) tax. The GST tax exemption isn’t portable. If you wish to provide for your grandchildren, therefore, you’ll need to use traditional estate planning techniques.

It may not be available for state estate tax purposes. If you rely on portability for federal tax purposes but live in a state that doesn’t recognize it for state estate tax purposes, you’ll forfeit any unused state exemption. (As of this writing, the states that have a separate estate tax system haven’t adopted portability.)

If your spouse remarries, the benefit may be lost. Portability is available only for a person’s most recently deceased spouse. If your spouse remarries and his or her second spouse dies, portability will be limited to the second spouse’s unused exemption, even if there is little or nothing left of it.

Is portability right for you?

If you believe that Congress will maintain the current estate tax regime and that you and your spouse’s combined estates won’t grow beyond $10 million, portability might work for you. Under those circumstances, you can avoid gift and estate taxes and achieve a stepped-up basis for your children with minimal estate planning.

If you and your spouse have estates worth more than $10 million or if you aren’t willing to take the risk that Congress will eliminate portability or reduce the estate tax exemption, traditional estate planning strategies may be your best bet.

Please confirm that you understand the consultation is paid and the fee is $350.