Saturday, June 4, 2011

Estate and Gift Tax Portability Law Creates some Unconventional Planning Opportunities

The Tax Relief Act of 2010 provides for "portability" of the unused estate tax exclusion amount to the surviving spouses of people dying in 2011 and 2012. The estate tax exclusion amount is $5 million dollars. Portability also carries over the gift tax exemption. However, portability does not apply to the generation skipping tax exemption.

Portability means that a surviving spouse can elect to harvest the unused portion of the estate tax exclusion amount of the deceased spouse, thereby providing the surviving spouse with a potentially much larger tax exclusion amount upon his or her subsequent death.  To preserve the first deceased spouse's unused exclusion amount (which is being referred to as the DSUEA), the personal representative of the deceased spouse must file an estate tax return and make an appropriate election on the return. The estate tax return must be filed to achieve portability even if the filing of such a return is not otherwise required.

Complicated limits apply to decedents with multiple predeceased spouses and only the most recent deceased spouse’s unused exemption may be used by the surviving spouse. See I.R.C. § 2010(c)(5)(B)(i). 

Portability was intended to simplify estate planning, but in some ways it may complicate it. For example, surviving spouses (and their lawyers) must now decide to whether to go to the expense of filing a federal estate tax return in order to preserve the DSUEA. In addition, estate planning lawyers fear that our clients may over-rely on portability for estate tax avoidance and use outright bequests to surviving spouses instead of traditional bypass (credit shelter) trust planning. However, the use of bypass trusts created at the first spouse’s death may still be advantageous for many reasons:
  • Portability may be lost if the surviving spouse remarries and survives the second spouse (because the DSUEA may only be used for the “last” deceased spouse);
  • Portability will be lost if an election is not made on a timely filed estate tax return of the first to die spouse;
  • Bypass trusts protect the appreciation that occurs in trust assets from estate tax at the second spouse’s death;
  • Bypass trusts provide many non-tax advantages such as protection of assets from creditors and the ability to restrict transfers by the surviving spouse;
  • There is no portability of the generation skipping tax (GST) exemption. In order to fully leverage the GST exemptions of both spouses to mitigate estate taxes in subsequent generations, a trust needs to be created at the first spouse’s death.
On the other hand, estate plans that leave everything to the surviving spouse (and rely on portability) offer the advantages of simplicity and a second step-up in basis at the surviving spouse’s death. 

Marital status has always been an important factor in estate tax planning. But these new portability provisions bring marriage and divorce into play more than ever.  

Elder law attorneys are familiar with divorce as a potential planning technique in the context of protecting a surviving spouse's assets from Medicaid spend down. Fortunately, the availability of planning using Medicaid annuities has reduced the need for this drastic remedy. (See my earlier post on this use of annuities: "Medicaid Annuities protect your assets if your husband or wife needs a nursing home.")

Now, some commentators are suggesting that portability (which most assume will survive the sunset of the current law in December 2012) could create some interesting new estate tax planning techniques involving marriage and divorce.  These include:
  • (1) marrying a poor dying person to be able to use his or her unused exemption amount (thus giving the survivor spouse an extra $5 million in gift and estate tax exclusions); 
  • (2) not remarrying to avoid the possible loss of the unused exemption of the first deceased spouse; and,
  • (3) divorcing and remarrying (spouses of wealthy families could divorce, each remarrying poor and sickly individuals which could create an additional $10 million of estate and gift tax exemption for the family).
Appalling visions of pre-marital agreements being signed in the rooms of hospice patients are enough to give this lawyer some nasty nightmares.  But under the new portability law - it’s possible. 

For more on portability see my earlier post "Portability Provision of Estate Tax law may be "Wolf in Sheep's Clothing."    

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