Educational Focus Series: Top 10 Possibilities of Portability

A significant opportunity presented by Uncle Sam, portability was first introduced as part of Tax Relief Unemployment Reauthorization and the Job Creation Act of 2010. It was scheduled to sunset on December 31, 2012 but was made permanent with passage of the American Taxpayer Relief Act of 2012. McManus & Associates, a top-rated estate planning law firm with offices in New York and New Jersey, today released the “Top 10 Possibilities of Portability.” Part of the firm’s Educational Focus Series, the discussion was led by Founding Principal and AV-rated Attorney John O. McManus, who shared guidance on transferring unused federal estate tax exemption amounts and the critical steps that must be taken to utilize this important estate and income tax tool.

LISTEN HERE: “Top 10 Possibilities of Portability”

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“Portability is one of the single best gifts that the IRS has given us,” commented McManus. “When people have failed to otherwise use gift tax exemptions, they now have the opportunity to pick up their late spouse’s exemption.”

In general, portability allows a surviving spouse whose husband or wife died after January 1, 2011 to use the Deceased Spouse’s Unused federal estate tax Exemption, otherwise known as DSUE. When one owns assets less than his or her lifetime exclusion amount and passes away first, portability has the potential to correct issues associated with unbalanced asset ownership between spouses and inefficient estate documents that leave all assets to the surviving spouse.

 Top 10 Possibilities of Portability

  1. Time is of the essence. To take Uncle Sam up on his offer, the decedent’s estate must make an election for portability on a timely-filed estate tax return.
    • The IRS may grant a reasonable extension of time to make an election if the taxpayer provides evidence to establish they acted reasonably and in good faith, and that granting relief will not prejudice government interests. Most often an extension of time to make an election is granted if the estate was not required to file a return.
    • The time limit on when the IRS can review the first deceased spouse’s estate tax return is extended until the statute of limitations runs out on the surviving spouse’s estate tax return (starting at 9 months and extension goes to 15 months).
    • The executor with counsel must include the computation of the DSUE amount for which the portability election is to be made.
  2. Executor in charge. Electing portability is the responsibility of an executor.
    • If there is no appointed executor, the “executor” for this purpose is any person in actual or constructive possession of property of the decedent (a “non-appointed executor”).
    • Multiple appointed executors are all required to sign an estate tax return in order for the return to be valid. There is no exception made for a return electing portability.
  3. Who makes the cut? DSUE can be used only by a citizen or permanent resident surviving spouse (not a non-resident alien), during his/her lifetime or at his/her death.
    • Portability is not available if the decedent was not a U.S. citizen or resident, unless otherwise provided by treaty.
    • If a decedent leaves property to a non-citizen spouse in a qualified domestic trust (QDOT), the DSUE amount of the decedent may be included in the surviving spouse’s applicable exclusion amount only after the QDOT assets have been distributed, the death of the surviving spouse, or early termination of the QDOT.
    • A non-US citizen surviving spouse is not able to use the DSUE amount from the deceased spouse to make lifetime gifts except in a situation in which the QDOT has been entirely distributed to the surviving spouse in a year prior to the surviving spouse’s year of death, the surviving spouse has become a U.S. citizen, or the gift was made by the surviving spouse in the year of death.
    • Same-sex surviving spouses who did not file for portability for a death after December 31, 2010 and before January 1, 2014 may file Form 706 and elect for portability retroactively, provided that the executor was not required to file an estate tax return.
  4. The ins and outs of portability. DSUE can be used during one’s lifetime and reported on Form 709 Gift Tax Return, or it can be used at death and reported on Form 706 Estate Tax Return.
    • Only the last deceased spouse’s unused exemption amount is portable. If the surviving spouse remarries and the second spouse dies, the surviving spouse can only use the DSUE of the second deceased spouse.
    • However, the surviving spouse may use the first deceased spouse’s DSUE by making lifetime gifts while the first deceased spouse is the surviving spouse’s last deceased spouse (second spouse has not died).
    • Portability does not apply to the generation skipping tax (GST) exemption outside of trust as this exclusion is separate from the unified transfer tax credit available for estate and gift taxes.
    • The ported DSUE does not index for inflation, which contrasts with the possibility to shelter from estate tax all growth in a credit shelter trust
  5. “Lifetime gifting” – pass it down. Use DSUE to make lifetime gifts, especially if the surviving spouse remarries.
    • Gift assets into grantor trusts for descendants up to the unused federal exemption amount, which would pass state estate tax-free.
    • Be careful in states that have a gift tax (Connecticut and Minnesota).
    • Grantor trusts allow the surviving spouse as the grantor to pay income tax to further grow the assets in trust.
    • The surviving spouse would need to give up control of the assets in trust, but could still borrow against those assets, as well as ”direct” the assets by appointing and removing trustees
  6. Continue to place trust in trusts. Portability is a valuable estate planning tool, but it does not negate the need for trusts to capture state estate tax exemptions and for asset protection.
    • Since state exemptions are not portable, continue to fund credit shelter trusts with the state estate tax exemption amount ($675,000 in NJ; $3,125,000 in NY; and $2,000,000 in CT). Within the credit shelter (state exclusion) trust, the state estate tax exemption is captured (sheltered) for the first deceased spouse’s estate so that both spouses fully utilize the state exemption amount lowering estate tax on their combined estates.
    • All growth in the credit shelter trust will also pass estate tax-free to the remainder beneficiaries (i.e. the children).
    • Amounts above the state exemption should also be in trust (a QTIP (marital) trust) as opposed to outright to provide asset protection for the surviving spouse against attack from third parties. Having the surviving spouse serve as trustee allows for flexibility.
  7. Look before you leap! Planning considerations have shifted with changed tax rates. The traditional strategy of funding a family trust and a marital trust for the surviving spouse now demands more in-depth analysis.
    • The capital gains tax rate has increased and is now a higher rate than state estate tax.
    • Instead of funding into a traditional credit shelter trust with only a step-up at the first spouse’s death, it may be better to fund certain assets into a GST exempt QTIP trust and get a second step-up at the surviving spouse’s death, as well as a GST exempt transfer. A GST-exempt QTIP would also provide for asset protection. This trust will be included in the surviving spouse’s estate but can utilize the ported DSUE to reduce federal estate tax on the second spouse’s death.
    • Low-basis assets (which will experience significant tax on sale) can then be captured in the estate of the surviving spouse to get a second step-up in basis on the surviving spouse’s death.
    • The DSUE will ensure that no federal estate tax will be due on the surviving spouse’s estate provided the total estate is under $10.86MM
    • A less significant state estate tax cannot be avoided, but the step-up in basis on the assets in the surviving spouse’s estate could save over $1.0MM in tax on the gains.
  8. All things considered… How and when to use portability should be evaluated on a case-by-case basis because estate plans are not one-size-fits-all.
    • A surviving spouse who has a DSUE amount should take this into account when negotiating a premarital agreement with a new spouse, and either obtain compensation for the DSUE amount that will be lost (since the new spouse impacts the amount to be ported) or have the new spouse create a lifetime credit shelter trust with assets comparable to the DSUE surrendered from the earlier spouse.
    • There must be an independent fiduciary (executor) who will elect what is in the best interests of the estate, as there may be inherent competing interests.
    • For some individuals, the portability election should be referenced in the estate plan. A provision directing the executor or trustee to elect portability of any unused exemption could be prudent, particularly if it is a second marriage and the children do not want their surviving step-parent to have the exemption or other situation where family tension is likely.
  9. States have yet to follow in the footsteps of Uncle Sam. Portability is not applicable on the state level.
    • Currently, there is no portability for the state estate tax exemption amount.
    • It is still necessary to capture the state estate tax exemption amount in a trust to ensure that both spouses’ state exemptions are maximized.
    • New York has been explicit that its move to equalize the state exemption with the federal exemption does not include portability.
    • Even when combining exemptions, there will likely still be a state estate tax.
  10. Should it stay or should it go now? It’s important to recognize that portability may not last forever.
    • Portability could disappear if the tax law changes; however, it attracted strong bipartisan support in Congress.
    • If portability is eventually repealed or modified, those who rely on it as an estate planning device could pay millions in unnecessary taxes if they have not already made the election.
    • Balancing the use of portability and trusts for the surviving spouse may provide the best protection against estate tax moving forward.
    • There must be a keen analysis performed after death to address the long term consequences, and if possible a pre-mortem analysis performed to assure that investment positions are still properly held.

For first-class assistance with estate and income tax planning, call McManus & Associates at 908-898-0100.