Portability Under the New Estate Tax Act – A Case of Timing?

By: Randall A. Denha, Esq.

On December 17, 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 into law. A big part of this new law is modification of the federal estate tax rules, including offering a new concept called “portability” of the federal estate tax exemption between spouses for the 2011 and 2012 tax years. But what does “portability” of the estate tax exemption mean?

Definition of Portability of the Estate Tax Exemption
In simple terms portability of the federal estate tax exemption between married couples means that if the first spouse dies and doesn’t use up all of his or her federal exemption from estate taxes, then the exemption that the deceased spouse didn’t use will be transferred to the surviving spouse’s exemption so that he or she can use the deceased spouse’s unused exemption plus his or her own exemption when the surviving spouse later dies.

Examples of Portability of the Estate Tax Exemption
Some examples using numbers should help to illustrate the concept of portability of the federal estate tax exemption between spouses:

Result Without Portability
Assume Sam and Amal are married and have all of their assets jointly titled and their net worth is $8,000,000. Sam dies first, the federal estate tax exemption is $5,000,000 on the date of his death, and there isn’t portability of the estate tax exemption between spouses:

1. Under these facts, when Sam dies his estate won’t need to use any of his $5,000,000 estate tax exemption since all of the assets are jointly titled and the unlimited marital deduction allows Sam to transfer his share of the joint assets to Amal without incurring any federal estate taxes.

2. Assume that at the time of Amal’s later death the federal estate tax exemption is still $5,000,000, the estate tax rate is 35%, and Amal’s estate is still worth $8,000,000.

3. With Sam’s $5,000,000 estate tax exemption completely wasted, when Amal later dies she can only pass on $5,000,000 free from federal estate taxes. Thus, Amal’s estate will owe about $1,050,000 in estate taxes after her death:

$8,000,000 estate – $5,000,000 exemption = $3,000,000 taxable estate

$3,000,000 taxable estate x 35% estate tax rate = $1,050,000

1. As above, when Sam dies his estate won’t need to use any of his $5,000,000 estate tax exemption since all of the assets are jointly titled and the unlimited marital deduction allows Sam to transfer his share of the joint assets to Amal without incurring any federal estate taxes.

2. Assume that at the time of Amal’s later death the federal estate tax exemption is still $5,000,000, the estate tax rate is 35%, and Amal’s estate is still worth $8,000,000.

3. Enter portability of the estate tax exemption – With full portability of the estate tax exemption between spouses, under these facts Sam’s unused $5,000,000 estate tax exemption will be added to Amal’s $5,000,000 exemption, in turn giving Amal a $10,000,000 exemption.

4. Since Amal has “inherited” Sam’s unused estate tax exemption and she can pass on $10,000,000 free from federal estate taxes at the time of her death, Amal’s $8,000,000 estate won’t owe any estate taxes at all:

$8,000,000 estate – $10,000,000 exemption = $0 taxable estate

5. Thus, portability of the estate tax exemption will save the heirs of Sam and Amal $1,050,000 in estate taxes.

This “portability” provision is intended to avoid the need for “Family Trusts” in estate planning documents. Unfortunately, both spouses must die before 2013 in order to benefit from the portability provision (without further Congressional action). My recommendation is to continue to use Family Trusts as the preferred planning tool. A Family Trust continues to provide significant additional benefits beyond just the use of each spouse’s estate exemption. These include the following:

• Ensuring that assets contained in the Family Trust pass to the children of the couple and not to any new children of the surviving spouse.
• Ensuring that the appreciation on the assets contained within the Family Trust, which may exceed the applicable exclusion amount at the surviving spouse’s death, are not subject to estate tax at that time.
• Protecting assets in the Family Trust from creditors of the surviving spouse, including any marital claims of future spouses.
• Sheltering the first-to-die spouse’s GST exemption (which is not portable.)

One thing to keep in mind is that if the first spouse to die’s executor doesn’t file an estate tax return, the entire benefit will be lost. Put another way, it’s not automatic. No one should consider using “portability” as their estate plan. It just will not work in too many situations because of the many limitations and issues involved in using it. In fact, “portability” should only be used as a last resort after the fact in most cases.