Portability – Overview

Portability of Unused
Exemption

Prior Law Bypass Trust, Asset Title, and Other Complexities

Under the estate tax rules that applied in 2009 and prior
years, a married couple had to engage in rather complicated estate tax planning
to claim their entire family exemption. In 2009, this was $3.5 million per
person, or $7 million for a couple. It was less in prior years. If planning
were not properly addressed, all assets on the death of the first spouse to die
would pass to the surviving spouse. While there would be no tax on the first
death, assets would be doubled up in the surviving spouse’s estate and subject
to a greater estate tax. To avoid the negative estate tax consequence, the
couple would have to divide assets between them so that whoever died first
would have sufficient assets to fund a bypass trust (also referred to as an
applicable exclusion or credit shelter trust) on the first death with an amount
equal to the estate tax exemption. The assets in the bypass trust (including
all of their appreciation) would not be subject to estate tax at the second
spouse’s death.  The result of these rules is that many
taxpayers who incurred the expense and made the effort to properly plan their
estates could have avoided estate tax. But taxpayers who did not receive
sufficient advice, would leave their estates vulnerable to the estate tax. The
need for this type of planning, and the means to prevent unsuspecting taxpayers
from being ensnared by the estate tax, was to provide a mechanism to enable the
surviving spouse to benefit from the deceased spouse’s unused estate tax
exclusion. Such a mechanism has been provided for the first time in the
TRA.

TRA to the Rescue: Portability

So does the new portability paradigm avoid
complexity?  To some degree, but not as much as many
taxpayers may believe. As with so many “tax simplifications” (think about the
automatic allocation of GST exemption as an example), the simplification cure
can be worse than the tax complexity for which it was prescribed. It’s like the
old adage: “The cure is worse than the disease.”

The unfortunate reality is that for many taxpayers the
steps and decisions involved with portability may be quite complex. In many
situations, relying on the simplification portability is intended to provide,
will prove very detrimental. Assets held in a traditional bypass trust on the
death of the first spouse, could appreciate without limit and not be subject to
estate tax in the surviving spouse’s estate. If instead of a bypass trust, the
client opted for the cheaper “I love you will” leaving all of his or her estate
to the surviving spouse outright, then portability might come to the rescue to
protect the assets up to the amount of the portable exclusion. The incremental
benefit is that the assets included in the surviving spouse’s estate will
receive a step up in basis on the last-to-die spouse’s death. The assets in the
bypass trust will not.

Evaluating the Portability Options

This seems a bit like Goldilocks and the three bears trying to
figure out which porridge is just right.

• Porridge No. 1: If the estate of the surviving spouse
  is less than the aggregate of the surviving spouse’s exclusion as inflation
  indexed plus the first-to-die spouse’s non-inflation indexed exclusion, it
  would be advantageous from a purely federal tax perspective to use the
  outright bequest to the surviving spouse. This would provide the maximum
  basis step up on second death for all assets and avoid any federal estate
  tax cost (ignoring state estate tax issues, protections afforded by trusts,
  etc.). In this scenario, the bypass trust porridge would be too hot.
• Porridge No. 2: If the assets that could have been
  bequeathed to a bypass trust on the first death appreciate at a rate such
  that the aggregate of the bypass-able assets and the surviving spouse’s
  assets would exceed the first-to-die spouse’s exclusion (applied to the
  bypass trust) and the survivor’s exclusion, then it would be advantageous
  to fund the bypass trust to remove that excess appreciation from the
  surviving spouse’s estate and avoid the estate tax on the second spouse’s
  death. In this scenario, the bypass trust porridge would be just
  right.
• Porridge No. 3 Since the estate tax rate is now only
  35 percent if the surviving spouse resided in a state with no estate tax
  but with a high income tax rate, when combined with the federal income tax
  rate applicable on the surviving spouse’s death exceeded the estate tax on
  the portion of the estate that exceeded the available estate tax exemption,
  the second basis step up might be more valuable in terms of income tax
  savings than the savings in estate tax afforded by the bypass trust. In
  this scenario, the bypass trust porridge would be too cold.

The decision as to whether to fund a bypass trust, with
the complexities just described, will have to be made without the benefit of
hindsight. Thus, the determination as to which assets might fund the bypass
trust, the life expectancy of the surviving spouse, the likelihood of the
surviving spouse remarrying a new spouse who dies before the surviving spouse,
the appreciation potential of the assets used to fund the bypass trust, the
inflation increase in the surviving spouse’s exclusion, and many more
considerations will have to be evaluated to make the optimal decision. But in
many instances, instead of going through this analysis, the use of appropriate
trusts on the death of the first spouse will probably prove the safer bet and
well worth the cost involved. Similarly, non-married partners will likely find
trusts the way to go.