Estate (& Gift) Tax Exclusion Portability

The new portability of the basic exclusion amount between spouses and an increase in the basic exclusion amount may make estate planning easier for many estates. But these changes are only temporary. Your estate plans and documents may need to be revised to reflect the tax changes for 2011 and 2012 and for the uncertainty for 2013 and later years. Flexibility to deal with future changes is key.

For married individuals dying in 2011 and 2012, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Act) added a new, temporary portability provision allowing a surviving spouse to use any unused basic exclusion amount of a deceased spouse for gift and estate tax purposes. Portability of the exclusion between spouses and an increase in the basic exclusion amount would seem to make estate planning easier for many estates. However, unless extended by Congress, portability of the unused basic exclusion amount between spouses expires in 2013.

Planning before portability

Prior to the 2010 Tax Act, many married couples with estates that were greater than the applicable exclusion amount would set up an A/B (or A/B/C) trust arrangement. The first spouse to die would transfer an amount equal to the applicable exclusion amount to the “B” or credit shelter bypass trust. The B trust could benefit the surviving spouse and their children, but the B trust would be designed to bypass the surviving spouse’s estate. The balance of the estate would be transferred to the surviving spouse, either outright or using an A marital trust. In some cases, a “C,” “Q,” or QTIP marital trust was also used if the first spouse to die wanted to control who received the marital trust property at the second spouse’s death.

With a typical A/B trust arrangement, there would be no estate tax at the first spouse’s death. The B trust portion was protected by the applicable exclusion amount of the first spouse to die, and the A trust portion qualified for the marital deduction. The A trust would be includable in the second spouse’s estate, but would be protected (at least in part) from estate tax by that spouse’s applicable exclusion amount. The A/B trust arrangement insured that neither spouse’s applicable exclusion amount was wasted.

In some cases, especially if the married couple’s combined estates would exceed the total amount of both spouses’ applicable exclusion amounts, the spouses’ planning would also attempt to equalize estates in order to use both spouses’ applicable exclusion amounts, avoid higher graduated tax rates on the surviving spouse’s estate, and reduce total tax on both estates. In other cases, especially where the combined estates were less than the applicable exclusion amount, the first spouse to die might simply transfer everything to the surviving spouse and defer estate tax (if any) to the second spouse’s death.

Planning with portability

If you’re planning today, you could transfer everything to your spouse and, if you die in 2011 or 2012, your estate can elect to transfer your unused basic exclusion amount to your surviving spouse. Your spouse will then have an applicable exclusion amount equal to the sum of his or her own basic exclusion amount and your unused basic exclusion amount, which your spouse can use for gift or estate tax purposes. For example, if your estate transfers your $5 million unused basic exclusion to your surviving spouse, who also has a $5 million basic exclusion amount, your spouse then has a $10 million applicable exclusion amount to shelter property from gift and estate tax.

The new portability provision would seem to make planning easier, and there may be far less need to use A/B trust arrangements. But there are a few potential pitfalls to watch out for.

• Portability is set to expire in 2013. Will it be available when you and your spouse need it? A flexible plan might still include an A/B trust arrangement, just in case.
• If you are predeceased by more than one spouse, the unused basic exclusion of an earlier spouse could be lost. That is because you use the unused basic exclusion amount (if any) of your last deceased spouse. This may be another factor to consider when planning for remarriage.
• The unused basic exclusion amount that you transfer to your surviving spouse is not indexed for inflation after you die. If the property you transfer to your spouse appreciates after your death, the value of such property in your spouse’s estate could exceed your unused basic exclusion amount and could result in estate tax. With an A/B trust arrangement, appreciation on property in the B trust would be sheltered by your applicable exclusion amount.
• In order to make the unused basic exclusion election, an estate tax return will need to be filed even if estate tax is not owed.

Using the applicable exclusion amount now

Even with portability, it may be useful to take advantage of the increased applicable exclusion amount by making gifts now that can reduce your taxable estate. Some reasons for using the applicable exclusion amount now might include:

• There are family members or individuals other than your spouse that you would like to provide for during your lifetime. The applicable exclusion amount could be used to shelter gifts to such persons from gift tax. (Consider also lifetime gifts that qualify for the annual gift tax exclusion, currently $13,000 per donor/donee, or as qualified transfers for medical or educational purposes. These gifts are not taxable and do not use up your applicable exclusion amount.)
• In the future, the available applicable exclusion amount may be less, portability may not be available, and tax rates may be higher.
• Appreciation on gifts you make is removed from your gross estate. For example, if you made a gift of $5 million now and the property doubles in value to $10 million in the future, the $5 million of appreciation would be removed from your gross estate. On the other hand, such property will not receive a stepped-up (or stepped-down) basis at your death for income tax purposes.
• If you would like to benefit your grandchildren and later generations, it may also be useful to use your $5 million generation-skipping transfer tax (GSTT) exemption now. The GSTT exemption is not portable between spouses and is scheduled to decrease to $1 million as indexed in 2013. Applicable exclusion amounts will often be used with generation-skipping transfers to protect the transfers from gift and estate tax.
• State death taxes can be saved. Most states do not have a gift tax. Making a gift can remove the property from your estate for state death tax purposes. Also, state exclusion amounts may be different than the federal applicable exclusion amount and may not be portable between spouses. Consult a tax or estate planning professional familiar with the laws in your state.

For many of the same reasons discussed above, it might also be useful to have your estate use all of your applicable exclusion amount at your death rather than transfer the unused exclusion to your spouse. For example, it might make sense if there are persons other than your spouse that you would like to benefit prior to the death of your spouse. In some cases, it may be useful to use A/B trust arrangements.

Estate plans and documents

Estate plans and documents written prior to the 2010 Tax Act may no longer carry out your intended wishes because of the new portability provision or the increased applicable exclusion amount. Your trusts and wills should be reviewed to see if they still meet your needs.

For example, if you have an estate of $5 million and an A/B trust arrangement that would fund your credit shelter trust with the applicable exclusion amount, would you want your B trust to be funded with the full $5 million, with nothing passing to your spouse (other than whatever interests your spouse might have in the B trust)? Or might you want to transfer the $5 million to your spouse who would be able to use your basic exclusion amount to protect the $5 million from gift and estate tax? But what if the applicable exclusion amount is reduced or portability is not available?

Your documents and plans may need to be revised to reflect the tax changes for 2011 and 2012 and for the uncertainty for 2013 and beyond. Flexibility to deal with future changes is key. Everyone’s situation is unique and the issues are complex. To help guide you through these opportunities and uncertain times, consult an experienced estate planning attorney.