In the American Taxpayer Relief Act of 2012 (“ATRA”), Congress made permanent (to the extent anything Congress does can be permanent) “Portability”.  What is it? Why is it important?  What is the price to be paid?  Does this mean I no longer need a trust?

What is it?

Portability is a creation of Congress to simplify death tax planning for larger estates.  It permits a surviving spouse to inherit the predeceasing spouse’s exemption from the federal death tax.

Why is it Important?

Prior to the 2010 Tax Relief / Job Creations Act, if a husband and wife had assets in excess of one federal death tax exemption amount, the couple needed to properly plan to avoid a death tax upon the second spouse’s death.

Consider the case where a husband and wife each have $4m worth of property, and the exemption from the federal death tax is $5m.  If the spouses have an “I Love You” estate plan where everything is left to the surviving spouse, there can be trouble.  When the first spouse dies, there is no death tax on property passing to the surviving spouse.  So far, so good.  But the surviving spouse now has his or her own $4m, plus the predeceasing spouse’s $4m, for a total of $8m.  Upon the death of the surviving spouse, there is now $8m of property, and a $5m exemption.  So, $3,000,000 of property will be subject to the federal death tax, with a 35% tax rate.  That’s $1,050,00 going to your favorite uncle, Uncle Sam.  (While I used a 35% rate in this example because that was the rate prior to 2012, the current death tax rate is now 40%, for a $1.2m tax bill!)

To avoid this problem, the traditional estate planning approach would be to have the predeceasing spouse leave property to a trust for the benefit of the surviving spouse.  The property left to the trust would utilize the predeceasing spouse’s death tax exemption, and would not be included in the surviving spouse’s estate. Upon the death of the surviving spouse, his or her property does not include the predeceasing spouse’s property, and is therefore less than the exemption amount.  From a $1.05m tax bill, we are down to zero.

Enter the Tax Relief/Jobs Creation Act of 2010.  Under this act, Congress said that a surviving spouse could inherit the predeceasing spouse’s exemption from the death tax.  Thus, they could use an I Love You estate plan; a trust would be unnecessary to avoid the death tax.  The surviving spouse would receiving spouse’s $4m of property, but also receive the surviving spouse’s $5m of death tax exemption.  Upon the death of the surviving spouse, there would be no death tax due.

The Tax Relief/Jobs Creation Act was set to expire on December 31, 2012.  The ATRA made portability permanent.

What is the Price to be Paid?

To obtain the benefit of portability, it is necessary to file a Form 706, a Federal Estate Tax return.  The return is detailed and takes a lot of time to properly prepare.  As accountants and attorneys often bill on an hourly basis, the cost of preparation of this return is not cheap.  On this form, the surviving spouse can elect portability.

If the estate is less than the exemption amount from the federal death tax (in 2013, $5.25m), it is not necessary to file a federal death tax return.  But if the spouse wants to utilize portability, a Form 706 will nevertheless need to be filed.

Does This Mean Trusts are Obsolete?

If the only reason a trust is being created is for death tax planning, then portability means that you no longer have to create a trust.  But there are other reasons to use a trust, such as preventing a child from receiving too much money too early in life.  If the predeceasing spouse’s estate was less than one exemption amount, no federal death tax return would be required, so one needs to balance the cost of the trust against the cost of the preparation of a Form 706. What it comes down to is that portability is another tool in the estate planner and probate attorney’s tool belt.  There will be times when it is very useful, and other times not.

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