Sunday, March 18, 2012

Understanding Portability

-- By David A. Diamond

The two-year estate tax compromise package passed during the lame duck session of Congress and signed into law by President Obama on December 17, 2010, introduced a radical new concept into the estate tax law: “portability” of exemption between spouses.

Under prior law, the exemption was a “use it or lose it” proposition. If the first spouse to die did not use his exemption by leaving assets to the children or, more typically, in a credit shelter (or “bypass”) trust for the benefit of his spouse, the exemption was wasted. Consider the following hypothetical:

Homer and Marge have a community estate of $5 million ($2.5 million each) and no estate plan.  They have three children, Bart, Lisa, and Maggie.  Homer dies in 2007 when the estate tax exemption is $2 million. Because they had no estate plan, Homer’s $2.5 million estates passes to Marge outright, meaning she now has an estate of $5 million.  Marge dies in 2009 when the exemption is $3.5 million.  Marge’s $5 million estate exceeds her $3.5 exemption by $1.5 million, generating an estate tax of $675,000.

Why is there is an estate tax of $675,000?  What happened to Homer’s $3.5 million exemption?  The answer is that because Homer’s estate went to Marge outright, his exemption vanished.  He didn’t use it, so he lost it.

Had Homer and Marge visited an estate planning attorney, they likely would have been advised to establish a living trust with “A/B” provisions, i.e., Homer’s share of the estate up to his exemption amount ($2 million) would have been funneled into an irrevocable credit shelter trust and the balance ($500,000) would have passed into a revocable survivor’s trust for Marge, along with Marge’s own $2.5 million of assets.  Marge could serve as trustee of the credit shelter trust and receive distributions of income, as well as principal for her health, support, and maintenance.  When Marge subsequently died in 2009, her taxable estate would have been $3 million rather than $5 million. The $2 million in Homer’s credit shelter trust would not be included in her taxable estate because they were owned by a trust, not her. Because Marge’s exemption amount in 2009 was $3.5 million, Bart, Lisa, and Maggie would inherit the entire estate tax free, saving $675,000.

Under the new portability rules, Homer and Marge could achieve the same tax savings without paying a lawyer to draft an A/B trust plan.  At Homer’s death, his $2 million “DSUEA” -- Deceased Spouse’s Unused Exemption Amount -- would pass to Marge along with his assets.  Marge would still have a $5 million estate, but under portability she would have had a $5.5 million of exemption (her $3.5 million plus Homer’s unused $2 million), wiping out the $675,000 estate tax bill.

So with portability of exemption, couples no longer need to hire a lawyer to draft an A/B trust plan anymore, right?  Wrong!  What if Homer has children from a prior marriage?  Homer may not need a bypass trust to save taxes, but he still needs one to ensure that his estate ultimately passes to his children at Marge’s death rather than to Marge’s next husband or Marge’s children from a prior marriage.

In theory, portability simplifies estate planning and reduces the cost of estate planning for married couples -- at least for those in first marriages.  But closer examination reveals that the purported cost benefits might not be realized in the long run.  The reason is that the only way to preserve the unused estate tax exemption of a deceased spouse is to file a timely estate tax return.  

Currently, an estate tax return is not required where the deceased spouse’s estate is less than the exemption amount. However, under portability, a surviving spouse would be well advised to file an estate tax return regardless of the size of the estate in order to preserve the DSUEA “just in case.”  After all, even if the surviving spouse does not have a taxable estate today, one cannot predict with reasonable certainty the value of the estate at death.  What if the surviving spouse wins the lottery or remarries and inherits from a wealthy second spouse or rich uncle? 

Thus, the legal fees the couple theoretically saved on estate planning services at the front end may instead be spent on estate tax return preparation costs at the back end.  So much for simplification and cost savings….

Portability of exemption is not a permanent part of the estate tax law. It is part of the two-year compromise that expires at the end of 2012.  If Congress does not act this year, the pre-2001 law will automatically reappear on January 1, 2013, with its $1 million estate tax exemption, 55% maximum rate, and no portability of exemption. Nevertheless, portability is supported by both parties and is likely to stay as part of any compromise.  In fact, it was included as part of President Obama’s transfer tax proposals released in February.

It looks like portability of exemption will be around for the foreseeable future, but stay tuned for further developments, especially as we approach the end of the year.

-- Dave

David A. Diamond
Hines Carr Diamond LLP
1561 Third St., Napa, CA  94559
Tel 707.258.6234 | Fax 707.258.6264 |
Certified Specialist, Estate Planning, Trust & Probate Law
California State Bar Board of Legal Specialization

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