Sunday, December 19, 2010

Portability Provision of Estate Tax law may be "Wolf in Sheep's Clothing"

The New Estate Tax Law May Create Complications for Middle Class Married Couples 

By Jeffrey A. Marshall, CELA*

The recently enacted Tax Relief Act of 2010 brings back the federal estate tax with a whimper not a bang. But one provision, intended to help married couples, may result in new tax complexities and expense for those of even very modest wealth.

Under the new rules, individuals who die in 2011 or 2012 will have an exemption amount of $5 million dollars (reduced if they made large gifts during lifetime). If their taxable estate does not consume the entire $5 million exemption, the unused portion can be passed on to their surviving spouse. However, the unused exemption amount is available to the surviving spouse only if an election is made and the amount is calculated on a timely filed estate tax return of the deceased spouse. This estate tax return must be filed to pass on the unused exemption even if no return is otherwise required.  

In its December 10th technical explanation of the provisions of the law, the Congressional Joint Committee on Taxation gives the following example of how this “portability” provision will work:  
“Example 1.−Assume that Husband 1 dies in 2011, having made taxable transfers of $3 million and having no taxable estate. An election is made on Husband 1's estate tax return to permit Wife to use Husband 1's deceased spousal unused exclusion amount. As of Husband 1's death, Wife has made no taxable gifts. Thereafter, Wife's applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death.”

In the Joint Committee example, it is pretty obvious that the relatively wealthy surviving spouse should hire a lawyer to prepare a federal estate tax return for her deceased husband. At a 35% tax rate, the unused $2 million dollar exemption could someday be worth $700,000 to her heirs.

But doesn’t this same logic hold true in the situation of a married couple with a much more modest net worth? Who knows what the future holds for the surviving spouse.

Assume that you are the lawyer meeting with a surviving spouse soon after the death of her husband.  The deceased had an “I love you” estate plan which leaves everything to his wife.  The value of his estate, for federal estate tax purposes, is $400,000. There is no federal (or state) tax and there is no requirement that a federal estate tax return be filed.  

But there is a $5 million dollar unused exemption that can be passed on to the surviving spouse – IF your client is willing to go to the hassle and expense of having an estate tax return prepared and filed. As the lawyer, how can you not suggest the filing of estate return to calculate the unused exclusion and elect to pass it on? How can you guarantee that the unused exclusion will not someday be incredibly valuable to your client’s children or other heirs?   At a 35% tax rate, an unused $5 million exclusion could someday be worth as much as $1.75 million dollars.

Note that the more modest the estate of the deceased spouse, the more potentially valuable the unused exemption. 

In my area of Pennsylvania, new technology has recently allowed for development of the gas resources of the Marcellus Shale. Mountain land that would have sold for under $1,000 an acre 10 years ago is now worth ten to twenty times as much.  A small farm or hunting land worth much less than $1 million 10 years ago may now be worth $10 million or more. The lesson is clear: surviving spouses can acquire unanticipated wealth.  

As a lawyer, I don’t want to find myself sitting across the table from my client’s children someday trying to explain why a million dollars in avoidable federal estate taxes is due because mom didn’t file an estate tax return when dad died. I’m not sure I would feel that much better even if I had some kind of a waiver signed by mom.

So, it seems to me that the portability provision in Title III of the new Tax Relief Act may be the proverbial wolf in sheep’s clothing.  It may create a lot of additional work for lawyers, and expense for our widowed estate administration clients of only modest net worth. 

Update: In September 2011, the IRS issued Notice 2011-82 Guidance on Electing Portability of Deceased Spousal Unused Exclusion Amount.

See also:

IRS publishes new Estate Tax Return Form (706) and Instructions.

Estate and Gift Tax Portability Law Creates some Unconventional Planning Opportunities 

*Certified as an Elder Law Attorney by the National Elder Law Foundation under authorization of the Pennsylvania Supreme Court


Anonymous said...

Jeff, maybe it's a sheep in wolf's clothing. You claim that the portability clause will create additional work for lawyers and expense for widows of modest net worth. A 706 for a modest estate need not be horrendously expensive, especially for an attorney or accountant who does them routinely. However, as you note, the exemption amount could be worth as much as $1.75 million if the surviving spouse comes into wealth, one way or another.

Unknown said...

I agree that the DSUEA/portability provision in the Tax Relief Act of 2010 present a new gamble for clients and their attorneys to contemplate. I think it is clear that attorneys will need to consider obtaining informed consent releases from executors not wishing to file the federal Form 706. However, given the "mega bucks" mentality of many, I think it is reasonable to assume that many will file a federal Form 706. In states that did not decouple, the election requirement may prove a trap for the unwary.

Smilie Rogers, Esq., York, Maine

Tax Relief said...
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