Journal of Financial Planning: June 2011
Randy Gardner, J.D., CPA, CFP® (gardnerjr@umkc.edu), is a professor of tax and financial planning at the University of Missouri Kansas City. He is also co-author (with Julie Welch) of the 10th edition of 101 Tax Saving Ideas and co-editor (with Leslie Daff) of the book WealthCounsel® Estate Planning Strategies.
Leslie Daff, J.D. (ldaff@estateplaninc.com), is a State Bar Certified Specialist in estate planning, probate, and trust law and the founder of Estate Plan Inc., an estate planning law firm with offices in Orange County, California, and Overland Park, Kansas.
Julie Welch, CPA, CFP® (Julie@meara.com), is the director of tax and a shareholder with Meara Welch Brown PC in Kansas City, Missouri.
Last December, Congress made significant changes to the estate and gift tax laws, including the following:
- For 2011 and 2012, Congress raised the estate, gift, and generation-skipping transfer (GST) tax exclusion amounts to $5 million and lowered the maximum tax rate to 35 percent. The $5 million exclusion is indexed for inflation starting in 2012.
- If Congress does not make the changes permanent, in 2013 the exclusion will revert to $1 million (adjusted for inflation) and the top tax rate will increase to 55 percent.
One surprise was the introduction of a provision that allows the executor of a deceased spouse’s estate to transfer the decedent’s unused applicable exclusion amount (“exclusion”) to the surviving spouse (“the portable exclusion”).
The Portable Exclusion
The new law allows the surviving spouse to use the deceased spouse’s unused exclusion amount (DSUEA) for estate and gift tax purposes. The deceased spouse’s unused generation-skipping transfer (GST) tax exclusion may not be transferred to the surviving spouse. The married couple must have satisfied several requirements for the surviving spouse to use the deceased spouse’s exclusion.
- The couple must be married when the first spouse dies.
- The surviving spouse’s election to use the DSUEA of the deceased spouse must be made on the timely filed Form 706 of the deceased spouse, even if the value of the assets of the deceased spouse is not greater than the $5 million that would require the filing of Form 706.
- As the law currently reads, both the first spouse and the second spouse must die after 2010 and before 2013. This requirement raises many questions. Does an unused DSUEA from a spouse who died during 2011 or 2012 simply disappear after 2012? President Obama has included as part of his proposed budget for 2012 that the portability provision be made permanent. It is likely Congress will make it permanent, but currently exclusion portability expires after 2012.
- The DSUEA may only be transferred to a surviving spouse. Interestingly, a surviving spouse’s exclusion amount can be reduced or increased if the surviving spouse remarries, as illustrated in the sidebar examples.
The Disappearance of the Bypass Trust
The availability of the portable exclusion changes estate planning for couples with large estates ($10 million in 2011 and 2012; $2 million after 2012 assuming portability is extended) in two important ways. First, couples no longer need to transfer assets to a lower-wealth spouse to ensure that both spouses can use their exclusion amounts. Under prior law, if the husband had $2 million of property, the wife had $9 million, and the law allowed a $5 million exclusion to each spouse, the couple was at risk if the husband died first of only using $7 million of exclusions. The challenge to the couple and their estate planner was how to transfer assets to the husband so he could use his full $5 million exclusion in the event he died first. This situation was particularly difficult if the couple’s marriage was unstable.
With the portable exclusion, it does not matter which spouse dies first—$10 million of assets will avoid estate tax. If the husband dies first, his $3 million DSUEA ($5 million minus the $2 million exclusion used to avoid tax on his property) will be added to his wife’s $5 million exclusion. If the portable exclusion sunsets in 2012, estate planners will again need to address how the couple’s assets are owned.
The second change the portable exclusion has brought about is decreased use of the bypass (“B” or “credit shelter”) trust. Prior to the law change, the first spouse to die’s separate property and his or her share of joint or community property, up to the amount of the exclusion, was either given outright to heirs or allocated to a B trust to ensure a couple did not lose the first spouse to die’s exclusion. With the portable exclusion, many planners are avoiding estate tax on the first death by using the marital deduction as they simply leave the estate to the surviving spouse outright or in a survivor’s (“A”) or QTIP (“C”) trust. To address the 2013 sunset issue, planners are incorporating language in their trusts allowing the surviving spouse to disclaim assets into a B trust at the first spouse’s death. Thus, if portability is not extended and/or the $1 million exclusion returns, the flexibility built into the trust document negates the need, expense, and hassle of rewriting the trust.
Many planners are advocating the use of B trusts even with the portability exclusion. The reasons most often cited include:
Uncertainty in the Law. The portable $5 million exclusion may disappear after 2012. Funding a B trust ensures that assets placed in the trust will avoid estate tax if the law changes.
Asset Protection. Depending on how the trust is drafted, assets placed in a B trust may avoid the creditors of the surviving spouse and may be subject to management oversight.
Asset Appreciation. Assets placed in a B trust may increase in value with the appreciation avoiding estate tax at the second death. If the law does not change, the surviving spouse’s $5 million exclusion is adjusted for inflation starting in 2012, but the DSUEA received from a deceased spouse is not increased for inflation. Although a stepped-up basis on the second death is not available, using a B trust provides appreciation protection that may not be available if the property is left to the surviving spouse.
Remarriage. Using a B trust provides remarriage protection in two ways. First, the assets placed in the B trust usually cannot be passed to a subsequent spouse of the surviving spouse. Second, the DSUEA passed to the surviving spouse may be decreased if the surviving spouse remarries, but the amount placed in a B trust avoids such a reduction.
State Estate Tax Laws. The portable exclusion is available at the federal level, but it has not been enacted at the state level, meaning for residents of states with an estate tax, a B trust may need to be funded to take advantage of a state tax exclusion.
Action Items for Planners
There are several important action items for planners:
- Many older plans require the creation and funding of A and B trusts. The formula for funding the B trust often required half the decedent’s property or the maximum amount that could avoid estate tax be allocated to the bypass trust. In light of the $5 million exclusion, this formula may lead to greater funding of the B trust than the couple wants. In light of the portable exclusion, the couple may want to amend their plan to allow discretionary funding of the B trust using a disclaimer.
- Surviving spouses who have recently lost a partner may need help with the decision whether to file a Form 706. If the partner died in 2010, the form may need to be filed to obtain a step-up in basis. If the partner died in 2011, the form must be filed to take advantage of the decedent’s unused portable exclusion.
- Surviving spouses who are contemplating remarriage and received an unused exclusion from a former spouse may need help evaluating the consequences of the remarriage on the available exclusion if one of the spouses in the remarriage dies.
- Because of the continued legislative uncertainty surrounding the estate tax, many individuals and couples are postponing devising a plan. With at least a $5 million “portable” exclusion as a cornerstone in the law for two years and likely longer, they should put a plan in place.
With the recent changes in the estate and gift laws, transfer taxes are eliminated as a concern for many couples—at least for the short term. The focus in estate planning is now on probate avoidance, asset protection, and distributing the property to descendants in a way that benefits generations to come.
Sidebar
Examples of How the New Portability Provisions May Increase or Decrease the Exclusion Amounts of Surviving Spouses
Example 1:
Paul and Linda are married. Neither has made any prior taxable gifts. Linda dies in 2011 leaving her entire $3 million estate to a bypass trust. Her executor makes an election on a timely filed federal estate tax return to permit Paul to use Linda’s $2 million unused exclusion amount (DSUEA). Consequently, Paul now has an applicable exclusion amount of $7 million (his $5 million basic exclusion amount plus the $2 million DSUEA received from his deceased wife).
Example 2:
If Paul (from Example 1) marries Yoko after Linda’s death and Yoko dies in 2012, leaving her entire $4 million estate to her child, she has only a $1 million DSUEA to pass on to Paul. As a result, Paul is faced with the reduction of his $7 million exclusion. That is, if Yoko’s executor makes an election on a timely filed federal estate tax return to permit Paul to use Yoko’s DSUEA, his applicable exclusion amount is reduced to $6 million. On the other hand, if Yoko’s executor does not make such an election or does not file an estate tax return, Paul’s applicable exclusion amount is limited to his basic exclusion amount of $5 million.
Example 3:
Referring back to Example 1, assume that Paul (with his $7 million exclusion), not Yoko, dies in 2012. Paul’s will leaves his entire $3 million estate to his children. Therefore, his DSUEA is $4 million. If Paul’s executor makes an election on a timely filed federal estate tax return to permit Yoko to use Paul’s DSUEA, her applicable exclusion amount increases to $9 million.