By: Stephen R. Elville, J.D., LL.M.
Portability represents the single biggest change in the estate tax laws since the implementation of the unlimited marital deduction in 1981. Understanding the mathematical import of Portability as the numbers relate to you and your estate plan could have huge financial implications for your heirs – an impact just as significant, if not more so, than any previous tax planning routinely done (marital deduction planning) prior to the advent of Portability. What is Portability? It is the ability of a surviving spouse to utilize the unused estate tax exemption of his or her deceased spouse by filing a timely federal estate tax return (Form 706). Practically speaking, the personal representative (executor) of the deceased spouse’s estate chooses whether to utilize the estate tax exclusion amount of the deceased spouse ($5,430,000 in 2015) in the decedent spouse’s estate, or transfer the deceased spouse’s unused exclusion amount (DSUE) to the surviving spouse. For estates equal to or exceeding the exclusion amount, there is no forgiveness and therefore no extension of time allowed to file the federal estate tax return. However, for estates valued at less than the exclusion amount, an extension of time may be allowed. The basic exclusion amount is indexed for inflation and is scheduled to increase to $6 million by 2020, assuming no change in the current laws. However, the DSUE is not indexed for inflation and its value is frozen upon election.
Portability is, first and foremost, about taxes – about an analysis of estate tax versus income tax implications. Portability concerns itself with the more human elements of planning (i.e. spousal control, spendthrift protection, bloodline control, etc.) only to the extent that these considerations are consequential to the numerical tax analysis of the Portability concept.
Portability was designed for married couples with estates of $5 million or less, and for married couples with estates of two exclusion amounts or less, all of whom wish to simplify the planning process, minimize tax reporting, lower the cost of administration, and streamline tax election concerns. However, for couples with combined estates exceeding two exclusion amounts (currently $10,860,000), mathematical analysis indicates that the traditional estate tax planning additional advantages begin to outweigh and eclipse the income tax and other ‘advantages” of Portability (discussed below).
Portability-type planning involves several choices, most of which include leaving assets to your surviving spouse in a manner that qualifies for the unlimited marital deduction (the ability for married couples to leave assets to the surviving spouse with no tax, with the consequence that those assets are then taxed in the estate of the surviving spouse), thereby achieving a step up in basis (new cost basis) not only the death of the first spouse, but also on the death of the second spouse – a double cost basis adjustment and avoidance of income tax upon receipt of your heirs (except for retirement assets, savings bonds, and other items of income in respect to a decedent). This means that for the first time in history, couples can leave unprecedented amounts to each other and to their beneficiaries estate tax free, and to the maximum extent possible, income tax free.
It is important to note that in the Portability versus traditional planning analysis, even where all due diligence is performed in the planning process, mathematical outcomes are ultimately dependent on how long the surviving spouse lives and the future rate of return on assets.
There are several approaches to planning in light of portability, including the following: (1) leave everything (100%) to the surviving spouse; (2) leave everything (100%) to a bypass trust (a trust controlled by the deceased spouse and taxed in the deceased spouse’s estate; (3) leave everything (100%) to a bypass trust but with the ability of a special fiduciary such as a trust protector or independent special trustee to grant a general power of appointment so that assets can pass by marital deduction if necessary or desirable; (4) leave everything (100%) to a QTIP trust or a Clayton QTIP trust; (5) leave everything (100%) to the surviving spouse where he or she then makes a large gift for purposes of immediately utilizing the DSUE amount (the DSUE, if elected, is used first prior to the surviving spouse’s basic exclusion amount); or (6) an approach combining one or more of the above. While all the above methods allow the surviving spouse to transfer or “port” their deceased spouse’s DSUE, the bypass trust approaches (numbers 2 and 3) are not true Portability-type plans due to the fact that any assets trapped in a bypass trust and not ultimately passing to the surviving spouse by marital deduction receive only one step up in basis (cost basis adjustment) at the death of the first spouse, the gain within the bypass trust being later subject to income taxation at the death of the surviving spouse.
In practical terms, Portability planning is about a married couple deciding on the best way to deal with the transfer of assets from one spouse to the other at the death of the first spouse. Unless the spouses wish to exercise a higher level of control over the transferred assets in further trust for the benefit of the survivor to include remarriage restrictions; or, alternatively, the spouses desire that the transferred assets be held in trust not only for the benefit of the surviving spouse, but also for the benefits of descendants; or unless the combined taxable estate of both spouses exceeds two basic exclusion amounts, then one of the “purely” Portability-type planning options outlined above would be appropriate.
Maryland will adopt Portability in 2019 when it adopts the current federal estate tax structure. Until then, many Maryland residents will continue some form of bypass trust planning to deal with Maryland estate planning, as Maryland remains one of the only states in the U.S. with a state estate tax and an inheritance tax. With a combined income tax rate of 29.55%, Maryland is also one of the states with a disparity between the federal estate tax rate of 40% and state long-term capital gains rates, making the decision to defer and avoid income taxes to the maximum extent possible through Portability planning a worthwhile and important endeavor.
It is important to understand the mathematics of Portability. An understanding of your tax planning objective(s) is key – are you planning to avoid estate tax and income tax to the maximum extent possible? Or, do other non-tax planning issues take precedence? Either planning focus is fine – so long as you know which one you have and why you are doing it.
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