Portability of estate tax exemptions: Should you rely on it?

One of the significant changes under the American Taxpayer Relief Act of 2012 (ATRA), signed into law back in January, was to make estate tax exemption “portability” permanent. When one spouse dies, portability allows the surviving spouse to use the deceased spouse’s unused exemption amount. This means that married couples can now maximize the benefits of their combined exemptions without the need for sophisticated estate planning involving multiple trusts.

Portability simplifies estate planning, but should you rely on it? Doing so may be appropriate under certain circumstances. But for many people, particularly the affluent, more-sophisticated strategies continue to offer significant benefits.

Life before portability

Before portability, the traditional approach for maximizing a couple’s exemption amounts was to employ an “A-B trust” arrangement. Generally, the “A” trust is a marital trust and the “B” trust is a credit shelter, or “bypass,” trust. For this strategy to be most effective, spouses should “equalize” their estates by, to the extent necessary, transferring assets from one to the other.

When one spouse dies, his or her assets are used to fund the credit shelter trust up to the exemption amount (currently, $5.25 million) less any gift tax exemption used during life. This trust benefits the surviving spouse for life and then distributes the remaining assets to the couple’s children or other beneficiaries. The excess, if any, goes into the marital trust, which benefits the surviving spouse and qualifies for the unlimited marital deduction. The assets in this trust are included in the surviving spouse’s estate.

This strategy avoids estate taxes on the first spouse’s death and minimizes estate taxes on the second spouse’s death. The credit shelter trust fully uses the first spouse’s exemption and, by limiting the second spouse’s access to the trust, keeps the assets out of his or her taxable estate. And if the first spouse’s estate exceeds the exemption amount, the excess goes into the marital trust, where it’s shielded from estate tax by the marital deduction. There may, however, be an estate tax liability on the second spouse’s death, depending on the size of his or her estate.

Life after portability

If you and your spouse have estates that total less than your combined exemption (currently $10.5 million) and are unlikely to climb above that amount, then portability should shield you against estate taxes without the need for trust planning. But if your estates exceed that threshold, an A-B trust arrangement remains the most effective strategy for minimizing estate taxes. (See “Why the affluent still need credit shelter trusts” below.)

Even if your combined estates are less than $10.5 million, however, trust planning offers several important benefits:

Asset protection. Portability allows you to leave your wealth to your spouse outright without wasting your estate tax exemption. But it does nothing to protect those assets from your spouse’s creditors or financial mismanagement. Well-designed and managed trusts remain the most effective way to protect your assets and preserve them for future generations.

“Freezing” of asset values. When assets are placed in a credit shelter trust, their value is frozen for estate tax purposes. Any future appreciation bypasses your surviving spouse’s estate. But if you rely on portability, future appreciation will be included in your spouse’s estate. If appreciation brings the value of your spouse’s estate above your combined exemption amounts, it can trigger an unexpected estate tax liability.

Remarriage protection. Trust planning ensures that your children are provided for, even if your spouse remarries. A credit shelter trust prevents your spouse from spending your children’s inheritance on his or her new spouse or on children from the subsequent marriage. It also avoids potential loss of portability benefits in the event your spouse’s new spouse dies. Portability is available only for a person’s most recently deceased spouse. If your spouse remarries and his or her new spouse dies, portability will be limited to the new spouse’s unused exemption — which could be little or nothing.

Generation-skipping transfer (GST) tax planning. The GST tax exemption (also $5.25 million this year) is not portable. So if you and your spouse wish to maximize your GST exemptions for bequests to your grandchildren, you’ll need to use trusts. (See “Using the GST tax exemption to build a dynasty” see the next edition of the newsletter for more on GST tax planning strategies.)

Also keep in mind state estate tax planning.  Unless your state’s law recognizes portability for estate tax purposes, you should consider using trust planning to preserve your state exemption amounts.

Plan carefully

Portability has the benefit of simplicity, but before you rely on it, review your situation and consider whether you’d be better off with more-sophisticated estate planning strategies. If you decide to rely on portability, keep in mind that it’s not automatic. A surviving spouse can take advantage of portability only if the deceased spouse’s executor makes an election on a timely filed estate tax return.

Sidebar: Why the affluent still need credit shelter trusts

Nick and Nora each have $10 million in assets. Nick dies in 2013, leaving all of his assets to Nora, for a total of $20 million. Nick hasn’t used any of his $5.25 million gift and estate tax exemption, and his estate files a portability election. When Nora dies 10 years later, the value of her assets has doubled, leaving her with a $40 million estate. For purposes of this example, assume that the exemption amount remains at $5.25 million and the tax rate is 40%.

Nora’s estate is subject to tax on $29.5 million ($40 million less her exemption and Nick’s exemptions), for a tax liability of $11.8 million. Had Nick’s estate plan placed $5.25 million in a credit shelter trust, Nora’s estate would have avoided tax on its appreciation in value — $5.25 million — for an estate tax savings of $2.1 million.

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