A quick explanation of the IRS portability rule: When the first member of a married couple passes away, the surviving spouse may carry over any unused portion of the deceased spouse’s estate tax exemption. Allowing “portability” of the deceased spouse’s unused exemption (DSUE) provides a substantial reduction in estate tax exposure for couples whose combined net worth is more than $5.49 million (2017), or, is expected to grow above that amount during the remaining lifetime of the second spouse. However, portability must be elected by filing an estate tax return within nine months of the date of death of the first spouse. The IRS had so many requests to allow portability, even when the nine-month deadline was missed, that the IRS now allows the portability election to be claimed up to two-years after the first spouse’s death.
The portability election went into effect in 2011. Prior to 2011, estate planning attorneys used a credit-shelter trust as the most effective method to preserve the estate tax exclusion upon the death of the first spouse. In our practice, we refer to a “credit shelter trust” as a Family Trust. Other attorneys may refer to these as bypass trusts as well. Regardless of the nomenclature, they are all referring to the same estate planning tool. Assets up to the exclusion were placed in the trust for the benefit of the surviving spouse and descendants. The assets in this Family Trust pass to designated beneficiaries free from estate tax upon the death of the surviving spouse. Here are just some of the reasons that we preach the value of using a Family Trust:
The Portability election must be elected by filing a death tax return. Yes, the IRS has generously allowed an extension of up to two years to file the portability election. However, in the real world, if the portability election was not done within the first nine-months (usually because trustees/executors are trying to settle an estate on the cheap and not get an attorney or other professional involved), more than likely the trustee/executor has no clue that the should have and the portability election is not done within the two-year requirement either!
The terrible beneficiary & Ted the Tennis Pro (or Betty the Barmaid). The married couple usually want the peace of mind that they know what will happen to their assets regardless of who dies first! For example, the surviving spouse may be influenced by a manipulative loved one to change beneficiaries, or even give the assets outright to a child whom the decedent spouse knows should get the protection of a lifetime trust (what happens if your kid hits the skids and the inheritance ruins their life?). Even worse, the surviving spouse could remarry Ted the Tennis Pro or Betty the Barmaid. The danger in this situation is unintentionally disinheriting your own children. The predeceasing spouse’s assets could end up with the children of the new marriage, or with the new spouse rather than the descendants the predeceasing spouse intended to benefit.
Portability only carries over the exclusion in effect at the date of death. The credit shelter trust exempts assets and any growth from estate taxes. If the first spouse dies with a $5.49 million exclusion, with portability the survivor will get exactly $5.49 million of exclusion to cover assets in the survivor’s taxable estate. If those assets have grown to $10 million or $20 million, that won’t get very far. If $5.49 million of assets were in the credit shelter trust and grew to $10 million or $20 million, they would all be free from the estate tax, and with proper planning should be GST exempt as well.
Portability is not effective for generation-skipping transfer tax (GST) exemption, only for the gift/estate tax exclusion. GST exemption is a great way to avoid inclusion in the taxable estate of the next generation. GST exemption is lost if portability is used. What does all this GST tax talk mean? What you leave to your kids could end up being included in the taxable estate of your grandkids. This is an avoidable problem.
The school bus full of lawyers problem. Planning to use portability assumes the assets are going outright to the surviving spouse. If the assets are left in a credit shelter trust, that trust may be drafted to protect the assets from the surviving spouse’s creditors or the surviving spouse’s mismanagement or substance abuse.
The second step-up basis smokescreen. One reason proponents of portability often use to “prove” that credit-shelter/family/bypass trusts are unnecessary, is step-up in income tax basis at the death of the second spouse. However, a credit-shelter/family/bypass trust can be drafted to get a second step-up in basis on the assets to the extent the inclusion does not cause an estate tax.