Tax & Business Insights

Portability: An Estate Tax Gamble

Volume 24 Issue 1 -- January/February 2012

In the seemingly roulette-wheel like process that produces our ever changing estate tax laws, the 2010 Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act (the 2010 Act), created another option and possible source of confusion for executors and estate planners to gamble on ó exclusion portability.

In a nutshell, the 2010 Act gives the executor of the second-to-die spouse (ďthe second spouseĒ) the ability to use any unused portion of the gift and estate tax exclusion amount of that personís previously deceased spouse  (ďthe first spouseĒ), if certain conditions are met.

For example, Bob and Mary are married. Bob dies in 2011 with a $3 million estate at a time when the estate tax exclusion amount is $5 million. While Bobís $5 million exclusion amount fully protects his estate from estate tax, he has $2 million of unused exclusion amount.

Mary dies in 2012 when the estate tax exclusion amount is $5.12 million with an estate of $6 million. Without being able to take advantage of Bobís $2 million unused exclusion amount, Mary would have a taxable estate of nearly $1 million. If Mary can use the $2 million exclusion amount that Bob did not use, then she has no taxable estate.

The 2010 Act potentially allows this. While this sounds simple enough, things are often not as they first appear.

The first problem is that in order for Mary to be able to use any portion of Bobís exclusion amount, Bobís estate must file a timely estate tax return (Form 706), even though the value of Bobís estate is less than the normal $5 million filing threshold. No special election is necessary, but filing the estate tax return on time is required to protect the right of the estate of the second spouse to use the deceased spouseís unused exclusion amount.

Conversely, if no estate tax return is filed for the first spouse to die or if it is not filed on time, the estate of the second spouse can use none of the first spouseís exclusion amount.

Moreover, regardless of the amount of time that passes between Bob and Maryís deaths, the IRS can audit Bobís estate tax return to re-determine how much of the exclusion amount is properly allocable to Bobís estate.

Thus, the IRS is not bound by the estate tax return as far as controlling the amount of the exemption used in Bobís estate, and the statute of limitations does not apply for this purpose.

For example if Bob died 25 years before Mary (assuming that this feature of the law is extended), the IRS could still go back and audit Bobís estate tax return, but solely to determine the how much of Bobís exclusion amount remains available for Maryís estate.

Does the availability of exclusion portability mean that simple ďI love my spouseĒ type wills are suitable for most clients? While it may seem like a no-brainer to rely on portability to obviate the need for complex estate planning in estates under $10 million, there are potential snags.

First, in order to use a prior spouseís unused exclusion amount, the second spouse cannot have remarried.  The law effectively limits the use of a deceased spouseís exclusion amount to the exclusion of the last deceased spouse.

Second, while a prior spouseís unused exclusion amount will offset gift or estate taxes, it will not apply to generation skipping transfer taxes.

Third, as the law is now written, the portability feature will expire at the beginning of 2013, unless the law is extended. Anyone care to predict what Congress may do?

Next, even if portability is extended, its ability to shield estates from tax depends upon the size of the exclusion amount. Under current law, that amount will revert to $1 million at the beginning of 2013. Of course, Congress may change that too.

In addition, the 2010 Act indexes the basic exclusion amount to inflation, but not the unused exclusion amount of a prior spouse. Thus, if Bob died in 2011 when the exclusion amount was $5 million and had a simple will that left everything to Mary, his $5 million unused exclusion amount will not increase because of inflation. Thus, if Bob left Mary $4 million and it grows at 4% a year, after 10 years, that $4 million will be worth about $5.92 million after 10 years, significantly more than Bobís $5 million unused exclusion amount available to Maryís estate.

On the plus side, using portability means that the entire combined estate of both spouses will qualify for a step-up in basis for income tax purposes at the death of the second spouse.

If you have questions about portability, please contact Tax & Business Professionals.  

Copyright 2012
By Tax and Business Professionals, Inc.
9837 Business Way
Manassas, VA 20110
(800) 553-6613

While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.

Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.