Here is a typical estate planning problem for our clients: Husband and Wife, both in their 60s, have a combined net worth of $9,000,000, with $8,000,000 titled in the Husband’s name and $1,000,000 titled in the Wife’s name. They wish to leave their assets to their two children with minimal taxes.
They are aware that with the current Exemption available for married couples, that they can leave their children up to to $10,680,000 free of Estate Taxes, but above that, the Estate Tax rate is a flat 40 percent. What they do not know is that this is easier said than done. This article will explain the traditional approach-without portability, and the new approach-with portability. Portability is the use by the second spouse to die of the first spouse’s unused Estate Tax Exemption.
Under the traditional approach, we would set up separate Revocable Trusts for each spouse. When the first spouse died, his or her assets would fund two subtrusts under the decedent’s Revocable Trust. First, we would use assets to fund the Credit Shelter Trust (also known as the Family Trust or the “B” Trust) up to the the available Estate Tax Exemption. The rest, if any, would be held in a Martial Trust (also known as the QTIP Trust or the “A” Trust) for the surviving spouse’s benefit for life. In this way, there would be no Estate Tax on the first death as the net assets are fully reduced to zero by the Exemption (Credit Shelter Trust) and, to the extent necessary, the Marital Deduction (Marital Trust).
Two problems with this approach. First, what if the first to die does not have sufficient assets to use his or her Exemption? To that extent, the Exemption will be wasted. As part of our strategy in order to fully fund the Credit Shelter Trust and thus fully use the exemption, we would need to consider a change in title of assets or the purchase of life insurance. Often it is not legally possible to change title to assets from the wealthier spouse (e.g., pension plans) or this could create other problems (e.g., second marriage). Second, and often more important, to the extent assets pass through the Credit Shelter Trust, the tax basis would only be adjusted to date of death values of the first to die. Assuming the assets appreciated over time, the children would end up paying Income Tax on the appreciation measured from the first death although they often don’t receive the assets until the second death.
As an example of the traditional approach without portability, Wife died first in 2014 with $1,000,000 in her name. $1,000,000 would go to the Credit Shelter Trust and nothing would go to the Marital Trust. There is no Estate Tax to pay because it is covered by the Exemption. The 2014 Exemption of $5,340,000 is offset by $1,000,000 used to fund the Credit Shelter Trust and the balance of $4,340,000 is wasted.
The problem is on the second death and we assume Husband dies in 2015. Assuming no change in Husband’s assets from 2014, he has $8,000,000 in assets with a 2015 Exemption of $5,430,000 and $100,000 in deductible administrative expenses. The Federal Estate Tax is 40 percent of $2,470,000 or $988,000 ($8,000,000 less $100,000 less the Exemption of $5,430,000) times 40 percent.
Enter portability and the new approach! Under the new Estate Tax law, any unused Estate Tax Exemption of the first to die can be added to the surviving spouse’s Exemption. For example, instead of using the two subtrusts described above, all assets of the first to die can be given outright to the surviving spouse or used to fund a Marital Trust for the lifetime benefit of the surviving spouse and which otherwise qualifies for the Marital Deduction.
By filing an Estate Tax Return for Wife (the first to die in our example) and electing portability, all of the $988,000 Estate Tax would have been saved as Husband could increase his Exemption by his spouse’s unused Exemption.
For example, Wife dies in 2014 and all her assets pass to her Husband or are held in a Marital Trust. Since these transfers qualify for the Marital Deduction, none of Wife’s Exemption is used and Husband has a potential $5,340,000 portable Exemption (i.e., carryover) from his Wife. He can add this portable amount to his Exemption at his death, if he meets three requirements.
First, a Federal Estate Tax Return will need to be prepared and filed for his Wife even though she has less assets than would otherwise require filing a Federal Estate Tax Return. Second, portability must be elected on such Return. Finally, portability is generally only permitted to be used by Husband from his last deceased spouse, with an exception.
Continuing our earlier example, If Husband were to die in 2015, he is permitted to transfer to his children (or others) the sum of the 2015 Exemption which is $5,430,000 plus the portable amount of $5,340,000 from his Wife for a total of $10,770,000. Unless his assets greatly appreciated, there would be no Estate Tax.
In most cases, the advantage of the new approach- transferring assets to the surviving spouse-either outright or in a Marital Trust -will normally qualify for an Income Tax basis measured at the death of the surviving spouse, assuming the assets are retained. Assets transferred to the Credit Shelter Trust have the basis determined as of the first death. If there is a significant amount of time between deaths, the increased Income Tax basis of the new approach could be a large Income Tax savings.
There are ways to build in flexibility so that the choice between the traditional approach and the new approach does not have to be made until after the death of the first to die.
In view of the new law, many of our readers should contact an attorney concentrating in tax and estate planning to have their estate plans reviewed. This is especially true for couples where the combined net worth is likely to approach or exceed the single Exemption amount at the time of the first death.