By Kevin Alerding and Steven Latterell
Gift and estate tax planning has gotten easier for married couples thanks in part to a relatively new concept: porting of the federal gift and estate tax exemption to a surviving spouse. Before porting was introduced in 2011, married couples often went to great lengths to split their assets, that is, to ensure that each of them owned approximately one-half of the couple’s wealth in his or her name alone. That way, regardless of which spouse died first, at least some of his or her federal estate tax exemption would be used. The exemption was a use-it-or-lose-it proposition, so any amount that was not used was wasted.
Many spouses found splitting assets to be unnatural. There also are practical and legal limitations on splitting. Retirement plan accounts, for instance, cannot be transferred to a spouse without onerous taxes and penalties, and corporate executive stock options often cannot be transferred at all.
Porting of the exemption has largely relieved couples from the hassle of splitting their assets. Now, if the first spouse to die does not use all of his or her exemption, the unused exemption can be transferred, or “ported,” to the surviving spouse. As an example, if a husband dies and leaves all of his property to his widow, and if neither of them had used any of the exemption through lifetime gifts, then the husband’s unused exemption ($5,340,000 in 2014) could be ported to his widow, who would add it to her own $5,340,000 exemption. The widow then could transfer $10,680,000 of property to her beneficiaries without paying any federal gift or estate tax.
Reasons to use portability
Most married couples’ goals are to benefit one another through their estate plans first, and then to benefit their children through the second spouse’s estate. Previously, achieving these goals required a “credit shelter trust” for the surviving spouse’s benefit. Today, through portability, a deceased spouse’s assets can transfer directly to the surviving spouse, the unlimited marital deduction is used to avoid estate tax, and the deceased spouse’s remaining exemption is ported to the surviving spouse, thereby avoiding a credit shelter trust and its associated costs and bookkeeping. Using portability can have the following further benefits:
• The surviving spouse will own the assets outright and without restriction (rather than through a credit shelter trust);
• The surviving spouse could leverage his or her increased exemption through a lifetime gifting strategy that can remain flexible over time; and
• When the surviving spouse later dies, the assets would receive a step-up in basis for income tax purposes.
This simplified plan certainly will benefit many couples. Still, portability, like most estate planning techniques, is not appropriate for all clients.
Reasons to avoid portability
Many clients have personal and financial circumstances that make it advantageous to establish a credit shelter trust instead of relying on portability.
1. Significant growth assets.
If assets are distributed outright to the surviving spouse under a portability plan, future growth on those assets would not necessarily be sheltered from estate tax in the second spouse’s estate. A credit shelter trust remains useful for managing such assets, because any growth on the trust’s assets should not be subject to estate tax in the surviving spouse’s estate.
2. Generation-Skipping Transfer Tax. One nuance of portability is that it does not apply to a person’s federal GST tax exemption (also a maximum of $5,340,000 in 2014). Thus, if the deceased spouse’s estate is distributed to the surviving spouse and portability is claimed, that deceased spouse’s unused GST tax exemption is lost. The use of a credit shelter trust or other trusts could ensure the GST tax exemption is not wasted.
3. Personal considerations. If a couple in a second marriage relies on portability and distributes all assets to the surviving spouse, then that surviving spouse would have total control of those assets and could later disadvantage or disinherit the deceased spouse’s children. A credit shelter trust would allow the surviving spouse to benefit from the trust during his or her lifetime and would direct the trust’s remainder to the deceased spouse’s children.
While not meant to be exhaustive, the following considerations could be drivers for avoiding portability too:
• risk of undue influence;
• potential mismanagement of assets;
• creditor concerns;
• potential remarriage; or
• transfers of family businesses, homes and other significant assets.
Changes have and will come
The relative newness of portability means that the law is still developing and is likely to see future adjustments. As evidence, earlier this year the IRS granted an extension that allows estate tax returns to be filed for portability purposes through the end of 2014 for some estates of persons who died in 2011, 2012 or 2013. This extends the typical nine-month filing deadline, but it is only available for certain estates with assets worth less than the decedent’s remaining exemption amount. This change, coupled with the recent United States vs. Windsor decision, means that the surviving spouse in certain same-sex marriages might now go back and port an unused exemption, even though that option was not available at the time of death.
In addition, the federal estate tax return instructions now confirm a summary process for disclosing assets that pass entirely to a surviving spouse or charity on a return that is being filed for portability purposes only. Asset values and appraisals are not required for those specific assets in order to utilize portability. Yet, an ounce of prevention may be worth a pound of cure, as without a formal appraisal it may be difficult to later prove a stepped-up basis for income tax purposes.
To port or not to port
While the apparent simplicity of portability is attractive and will operate effectively for certain families, it should not be relied upon without forethought. Estate planning rarely is driven solely by tax concerns, and it often involves personal, asset and other considerations. As ever, a custom-drafted estate plan that takes a flexible approach to a client’s unique circumstances is essential.•
Kevin Alerding is a partner in Ice Miller LLP’s trusts and estates group. His practice focuses on estate planning, business succession planning, estate and trust administration, and litigation involving estates and trusts. Steve Latterell is an estate planning and probate attorney in the Indianapolis office. He helps clients protect their assets and transfer them to loved ones and charities in a tax efficient and customized manner designed around each client’s specific needs. The opinions expressed are those of the authors.