Journal of Financial Planning: August 2011
Jon J. Gallo, J.D., chairs the Family Wealth Practice Group of Greenberg Glusker Fields Claman Machtinger & Kinsella LLP in Los Angeles, California. Together with his wife, Eileen Gallo, Ph.D., he is a founder of the Gallo Institute and the author of two books on children and money. Their websites are www.galloinstitute.org and www.fiparent.com.
The 2010 Tax Act1 has made it possible, under specified circumstances, for the estate of a surviving spouse to make use of the unused estate tax exemption of his or her predeceased spouse, a concept referred to as portability of the applicable exemption amount. Some estate planners have suggested that portability makes it unnecessary to continue to draft estate plans that include credit shelter trusts. This reported demise of the credit trust reminds me of Mark Twain’s famous observation, after his obituary had been mistakenly published by the New York Journal, that “The reports of my death are greatly exaggerated.” Like Mark Twain’s “death,” it seems to me that reports of the demise of the credit trust are greatly exaggerated.
Understanding portability involves mastering two new estate tax terms: the basic exclusion amount and the deceased spousal unused exclusion amount (DSUEA). The basic exclusion amount is the surviving spouse’s applicable exclusion of $5 million, reduced by lifetime taxable gifts. The DSUEA is the predeceased spouse’s applicable exclusion of $5 million, reduced by the sum of lifetime taxable gifts and taxable transfers at death. Portability exists because the surviving spouse’s applicable exclusion amount under IRC Sec. 2010 is now defined as the sum of his or her basic exclusion amount plus the DSUEA.
Tax Act Terms
As keen-eyed readers will note, the definition of the basic exclusion amount and the DSUEA provides the first hint that the importance of portability may be exaggerated. Both definitions include a reference to an applicable exclusion of $5 million, which is available under the 2010 Tax Act only for people dying during the 24-month period beginning January 1, 2011, and ending December 31, 2012. As of the date of writing this column, portability will exist only if both spouses die within the next 18 months.
A second fly in the ointment is created by Section 303(a)(5) of the 2010 Tax Act, which provides that the surviving spouse may only make use of his or her predeceased spouse’s DSUEA if the predeceased spouse’s estate files a timely estate tax return that shows the amount of the DSUEA and contains an irrevocable election to the effect that the surviving spouse may use such DSUEA. Advocates of using portability in lieu of credit trusts argue that portability reduces the cost of estate planning because plans relying on portability will be simpler documents to draft and the survivor will be faced with less post-death complexity because the number of trusts the survivor must contend with will be reduced. Both assumptions are questionable.
Portability vs. Credit Trust Costs
Portability may actually increase the cost of administration by requiring the filing of an estate tax return that otherwise would not be necessary. For example, assume that a husband dies in 2011 with an estate of $3 million, all of which he leaves to his wife, who has an estate of $5 million. No estate tax return is required because the husband’s estate is less than his applicable exclusion. In order for the wife to make use of the husband’s DSUEA, a timely estate tax return must be filed with the appropriate irrevocable election. The cost of preparing an otherwise unnecessary estate tax return could easily equal or exceed the cost savings of not including a credit trust in the husband’s estate plan. Moreover, complexity is actually increased because the client must not only file an otherwise unnecessary estate tax return but that return must be filed timely and must contain the appropriate election.
Reliance on portability in lieu of the use of credit shelter trusts creates several other problems as well. Although the 2010 Tax Act provides that the $5 million applicable exclusion amount is subject to an inflation adjustment, that adjustment ceases to apply once the taxpayer dies. Unlike a credit trust that shelters post-death appreciation in value, the amount of the DSUEA is fixed as of the date of the pre-deceased spouse’s death and does not protect post-death increases in value of the pre-deceased spouse’s assets. Returning to the example of the husband who dies in 2011 with an estate of $3 million, all of which is left to a widow with a separate estate of her own of $5 million, assume that the husband’s assets appreciate in value to $10 million and the widow dies on December 31, 2012. Had the husband left his estate in a credit shelter trust, the entire appreciated value of the assets would have been excluded from the widow’s taxable estate, as well as having been exempt from the generation-skipping transfer tax. Because the parties relied on portability, the husband’s DSUEA is fixed at $5 million. The surviving spouse’s taxable estate amounts to $15 million (her $5 million plus the husband’s $10 million) and her applicable exclusion amount is $10 million, consisting of her basic exclusion amount of $5 million and her husband’s DSUEA of $5 million. The remaining $5 million of the widow’s taxable estate would be subject to a 35 percent tax rate, producing an entirely unnecessary estate tax of $1.75 million.
Blended Family Estates
Reliance on portability may also defeat, either intentionally or unintentionally, the testamentary plan of the pre-deceased spouse. It is common today for one or both spouses to have children by prior marriages. There is no assurance that a surviving spouse who inherits outright the estate of his or her pre-deceased spouse will leave that property to the pre-deceased spouse’s children. It is equally common for a surviving spouse to remarry. If such a remarriage ends in divorce, it is possible that some or all of the inherited assets may be subject to division by the family law court. If the marriage is successful, it is equally possible that the surviving spouse will leave his or her new spouse some or all of the assets inherited from the pre-deceased spouse.
It is interesting to note that estate planners were having this same discussion of the drawbacks of leaving property outright to a surviving spouse in the 1960s and 1970s prior to Congress amending the estate tax laws to create the QTIP trust, thereby permitting a pre-deceased spouse to qualify for the marital deduction but still control the ultimate disposition of property left a surviving spouse. I am reminded of a George Santayana remark that those who cannot remember the past are condemned to repeat it. On the other hand, assets left in a credit shelter trust in which the surviving spouse has a life estate—like assets left in a QTIP trust—pass to the designated remainder beneficiaries at the surviving spouse’s subsequent death.
Tax Considerations
A credit trust is also potentially more tax efficient than reliance on portability. A properly drafted credit trust can be used to sprinkle taxable income to beneficiaries in lower tax brackets, which cannot occur when property is left outright to the surviving spouse. Principal distributions may be made from a credit trust to children during the lifetime of the surviving spouse without such distributions being treated as taxable gifts. If portability is relied upon and the pre-deceased spouse leaves his or her estate to the survivor, transfers by the surviving spouse to children during his or her lifetime will constitute taxable gifts to the extent they exceed the surviving spouse’s annual exclusion.
Lastly, planners should keep in mind that portability will sunset for people dying on or after January 1, 2013. Planners relying on portability are limited to factual situations in which both spouses die prior to that date. In most situations, it appears estate plans that use credit trusts are far more practical and far less dangerous than reliance on portability.
Endnote
- Officially, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Pub. L. No. 111-312, 124 Stat. 3296.